UNEDITED!

Global equity, currency, interest-rate, and commodity markets remain quite choppy. Technology issues led U.S. stocks this holiday-shortened week. For the week, the Dow gained 0.5% and S&P500 added 0.9%. The Transports were strong, rising 2.6%, while the Utilities were about flat, adding 0.1%. The Morgan Stanley Cyclical index gained 0.3% and the Morgan Stanley Consumer fell slightly by 0.3%. The broader market was very strong, with the small cap Russell 2000 finishing the week up 2.5% and the S&P400 Mid-cap index up 0.9%. The NASDAQ100 advanced an impressive 3%, and the Morgan Stanley High Tech index added 5%. The Semiconductors more than made up for last week's 6.4% loss by rising 7.2%. The Street.com Internet Index increased 4.1% and the NASDAQ Telecommunications added 4.9%. The Biotechs gained 1.9%. Financial stocks were mixed but generally higher, as the Broker/Dealers added 3.6% and the banks finished the week up 0.5%. With bullion gaining $1.40, the HUI index advanced 0.6%.

Intense buying pressure returned to the Treasury market after a one-week hiatus. For the week, 2-year Treasury yields declined 9 basis points to 2.44%. Five-year Treasury yields were down 10 basis points to 3.39%. Ten-year yields dipped 10 basis points to 4.19%. Long-bond yields ended the week at 4.98%, down 7 basis points on the week. Benchmark Fannie Mae MBS yields declined 10 basis points, in line with Treasuries. The spread (to 10-year Treasuries) on Fannie's 4 3/8% 2013 note narrowed 3 to 29, and the spread on Freddie's 4 ½ 2013 note narrowed 2 to 28. The 10-year dollar swap spread declined 2.5 to 45.25. Corporate bond spreads were generally little changed, with the exception of the auto sector that weakened. The implied yield on 3-month December Eurodollars dropped 10.5 basis points to 2.21%.

Corporate debt issuance totaled $15.9 billion this week, the strongest sales since January. Investment grade issuers included BellSouth $3.0 billion, JPMorgan $2.0 billion, Wells Fargo $1.6 billion, CVS $1.2 billion, Pfizer $1 billion, HBOS $750 million, and MGM $450 million.

Junk bond funds reported inflows of $127.9 million for the week (from AMG), with three-week inflows a notable $661 million.

Foreign dollar debt issuers included Philippines $2.8 billion, European Investment Bank $3.0 billion, and InterAmerican Development Bank $1.0 billion.

September 9 - Bloomberg (Matthew Keenan): "Emerging markets bond funds had net inflows for the fourth straight week, as concerns about rising U.S. interest rates faded, according to Emerging Portfolio.com Fund Research. The funds had $235.6 million in net new investments from Aug. 4 to Sept. 1, the Cambridge, Massachusetts-based company said in an e-mailed statement. The funds, which had outflows in 15 of the previous 17 weeks, now have $16.7 billion in assets, EPFR said."

September 10 - Bloomberg: "A speculative mood and a high degree of liquidity fuelled gains on Mideast stock exchanges this week and are likely to continue to do so, financial analysts said Friday. 'Speculation and a high degree of liquidity are believed to be the main dominant factors at this juncture,' Maher Muasher, head of the Brokerage Section at the Ahli Bank, told Deutsche Presse-Agentur dpa. Muasher spoke as bourses in Jordan, Saudi Arabia, Kuwait and Egypt scored fresh advances in the trading week ending Thursday."

Japanese 10-year JGB yields declined 3 basis points to 1.51%, with yields now down 43 basis points since June highs. Brazilian benchmark bond yields sank 20 basis points points to 9.22%. Mexican govt. yields ended the week at 5.39%. Russian 10-year Eurobond yields declined 5 basis points to 6.22%.

Freddie Mac posted 30-year fixed mortgage rates rose 6 basis points this week to 5.83%. Fifteen-year fixed mortgage rates added 7 basis points to 5.22%. One-year adjustable-rate mortgages could be had at 4.0%, up 3 basis points. The Mortgage Bankers Association Purchase application index jumped 7.4% last week. The holiday week distorts year-over-year comparisons. Refi applications gained 8%. The average Purchase mortgage was for $216,400, and the average ARM was at $298,100. ARMs accounted for 32.9% of applications last week.

Broad money supply (M3) declined $11.4 billion (week of August 30). Year-to-date (35 weeks), broad money is up $485.5 billion, or 8.2% annualized. For the week, Currency added $0.5 billion. Demand & Checkable Deposits added $1.0 billion. Savings Deposits dropped $17.6 billion. Saving Deposits have expanded $250.3 billion so far this year (11.8% annualized). Small Denominated Deposits were about unchanged. Retail Money Fund deposits dipped $3.4 billion, while Institutional Money Fund deposits declined $9.2 billion. Large Denominated Deposits jumped $15.9 billion, increasing at a 27.6% rate so far this year. Repurchase Agreements added $1.6 billion, while Eurodollar deposits were about unchanged.

Bank Credit jumped $33.7 billion for the week of September 1 to $6.645 Trillion. Bank Credit has expanded $370.3 billion during the first 35 weeks of the year, or 9.0% annualized. Securities holdings increased $15.1 billion, while Loans & Leases gained $18.6 billion. Commercial & Industrial loans dipped $1.9 billion, while Real Estate loans jumped $13.5 billion. Real Estate loans are up $203.7 billion y-t-d, or 14% annualized. Consumer loans declined $1.0 billion for the week, while Securities loans rose $10.4 billion. Other loans were down $2.4 billion. Elsewhere, Total Commercial Paper declined $7.5 billion to $1.355 Trillion. Financial CP dropped $9.7 billion to $1.355 Trillion, expanding at a 8.0% rate thus far this year. Non-financial CP added $2.2 billion (up 30.2% annualized y-t-d). Year-to-date, Total CP is up $86.5 billion, or 9.8% annualized.

ABS issuance totaled a strong $15 billion this week. Year-to-date ABS issuance increased to $416.8 billion, 38% ahead of comparable 2003.

Fed Foreign "Custody" Holdings of Treasury, Agency Debt rose $8 billion to $1.291 Trillion. Year-to-date, Custody Holdings are up $224.2 billion, or 30.4% annualized. Federal Reserve Credit jumped $400 million last week to $764.4 billion, raising y-t-d gains to $17.8 billion (3.5% annualized).

September 8 - Bloomberg (Hamish Risk): "The global market for credit derivatives last year grew 70 percent to more than $2.8 trillion, fueled by increased trading in credit-default swaps on single companies, Fitch Ratings said. Trading in so-called single name default swaps doubled to $1.9 trillion in 2003, the New York-based ratings company said in its annual survey of the credit-derivatives industry. Trading of contracts based on indexes, which let investors bet on a group of companies, increased 49 percent, the report said."

Currency Watch:

September 9 - Bloomberg: "Brazil's real rose to a 21-week high after Moody's Investors Service raised its rating on the country's sovereign debt for the first time since 2000. Moody's raised its foreign currency debt rating bonds to B1, four levels below investment grade, from B2. The increase, coming after debt sales by Brazil's government and Petroleo Brasileiro SA, the state-controlled oil company, may spark more sovereign and corporate foreign-currency bond offerings, said Siobhan Manning, chief emerging-market bond strategist at CAboto USA Inc. the New York investment-banking arm of Banca Intesa SpA, Italy's largest bank."

Currency markets remain brutal. For the week, the dollar declined better than 1.5%. The Swedish krona gained 2%, while the Danish krone and euro rose 1.6%.

Commodities Watch:

Commodities markets remain exceptionally volatile. For the week, the CRB index dipped 0.7%, lowering y-t-d gains to 6.4%. Although October crude was down $1.18, the Goldman Sachs Commodities index was little changed on the week (up 15.2% y-t-d).

China Watch:

September 9 - Bloomberg (Allen T. Cheng): "China's investment in factories, roads and other fixed assets rose 32 percent from a year earlier in August, faster than the growth rate for the first seven months, said a senior government economist. 'The figures indicate that there is a serious structural problem,' Wu Jinglian, a researcher at the cabinet-level State Development Research Center, said at a conference in Beijing. 'The government policies haven't been as effective as the media has been reporting them to be.'"

September 10 - Bloomberg (Philip Lagerkranser and Tian Ying): "China's industrial production growth unexpectedly accelerated in August, fueling speculation the central bank will raise its benchmark interest rate for the first time in nine years. Production rose 15.9 percent from a year earlier to 455 billion yuan ($55 billion) after climbing 15.5 percent in July, the Beijing-based National Bureau of Statistics said..."

September 10 - UPI: "Factories in southern China are facing a labor shortage as migrant workers seek better wages and working conditions elsewhere, a government survey shows. The study, released this week by China's Ministry of Labor and Social Security, said there was an estimated 10 percent labor shortage in the Pearl River Delta, Fujian and Zhejiang provinces, where factories are most concentrated. The Pearl River Delta alone reportedly requires an additional 2 million workers to meet present needs."

September 9 - Bloomberg: "China' exports rose 35.8 percent to $360.6 billion in the first eight months of this year, according to International Business Daily, a commerce ministry publication. Imports increased 40.8 percent to $361.5 billion, giving a trade deficit of $900 million, the newspaper said, citing customs bureau figures. Total trade surged 38 percent to $722.1 billion in the first eight months, it said."

September 9 - XFN: "China's shipbuilding tonnage is expected to reach a new record of more than 8 million tons this year, up some 30% from a year earlier, on the back of booming domestic and international markets, the China Daily reported. Citing statistics released by the China Association of National Shipbuilding Industry, the state-run newspaper said tonnage increased by 66% year-on-year during the first half 2004 to 4.09 million tons..."

September 8 - Bloomberg (Le-Min Lim): "China's economic growth will probably slow to 9 percent in the third quarter as government lending curbs take effect, the official Xinhua news agency reported... The economy, Asia's biggest after Japan, expanded 9.6 percent from a year earlier in the first half and Qi, who works for the State Information Center, expects growth to average 7 percent this year, the report said."

Asia Inflation Watch:

September 10 - Bloomberg (Seyoon Kim): "South Korea' government plans to increase spending by 9.5 percent to 131.5 trillion won ($115 billion) next year, the ruling Uri Party said... The Ministry of Planning and Budget said last week it planned to boost spending to 132 trillion won in 2005 from 120.1 trillion won this year. The ministry said the 2005 budget will be discussed at a Cabinet meeting on Sept. 21 before it is submitted to the National Assembly in Seoul for approval on Oct. 2."

September 9 - Bloomberg (Clare Cheung): "Hong Kong may fetch as much as HK$11 billion ($1.4 billion) in the Oct. 12 land auction, the biggest sale since the height of the property boom in 1997, as developers vie for land amid a revival in the real estate market."

September 10 - Bloomberg (Cherian Thomas): "India's industrial production accelerated faster that expected in July as the cheapest credit in three decades and record farm incomes boosted demand for homes, cars and other consumer goods. Production at factories, utilities and mines rose 7.9 percent from a year earlier, faster than the 7.5 pace in June..."

September 7 - Bloomberg (Subramaniam Sharma): "India estimates that costs have increased a fourth on average, or a total of about $10 billion, on government projects surveyed by the statistics ministry, mostly because of delays in completion. The 300 projects examined, which include power plants, railway lines, fertilizer factories and highways, will cost 2.47 trillion rupees ($53 billion) compared with the initial estimate of 2.02 trillion rupees, the ministry said in a statement..."

September 7 - Bloomberg (Theresa Tang): "Taiwan' exports rose 20 percent in August as the island's electronics makers shipped more flat-panel displays, computer chips and other electronic goods. Shipments increased to $14.8 billion after climbing 26 percent from a year earlier to $14.7 billion in July, the Ministry of Finance said in a statement in Taipei. The government said it expects overseas sales to rise 23 percent this quarter and 17 percent in the final three months of the year."

Global Reflation Watch:

September 10 - Bloomberg (Alexandre Deslongchamps): "Canadian housing starts rose to an annual pace of 241,500 units in August, an increase of 10 percent from the previous month and the fastest pace since March, the federal government's housing agency said. Urban construction increased 12 percent to 214,700, and starts of multiple-unit homes in cities jumped 36 percent to 114,600, Canada Mortgage & Housing Corp. said..."

September 10 - Bloomberg (Lily Nonomiya): "Japan unexpectedly cut its estimate for second-quarter economic growth to a 1.3 percent annual pace, the slowest in more than a year, as some manufacturers reduced inventories on concern orders may fall. Stocks and the yen slid. The pace of growth announced by the Cabinet Office in Tokyo was lower than the initial estimate of 1.7 percent..."

September 9 - Bloomberg (Christian Baumgaertel): "The European Central Bank said prices for residential buildings have risen so fast in some European countries they need 'close monitoring,' suggesting it's worried the lowest credit costs in six decades may push up inflation. Residential property prices in the dozen euro countries rose 7.2 percent last year, the most in a decade..."

September 10 - Bloomberg (Mark Bentley): "Turkey's gross national product, the country's main indicator of economic output, leaped an annual 14.4 percent in the second quarter, the fastest in at least 17 years, amid a surge in investment and consumer pending. Consumption jumped 16 percent in the three months through June, the State Institute of Statistics said... Investment outside of the government sector soared 68.7 percent. Turkish growth, fueled by consumer loans and credit card spending, is raising concern that the country's burgeoning current account deficit may undermine the lira and boost inflation..."

U.S. Bubble Economy Watch:

September 10 - New York Times (Milt Freudenheim): "The cost of providing health care to employees has risen 11.2 percent this year, according to the results of an authoritative national survey reported yesterday. It was the fourth consecutive year of double-digit increases in health insurance premiums, which has resulted in a steady decline in the number of the nation's workers and their families receiving employer health care coverage. The annual survey of 3,000 companies, conducted between January and May by the Kaiser Family Foundation and Health Research and Educational Trust, is considered a reliable indicator of health care costs paid by companies and their workers. Small businesses are being especially hard hit as the average family coverage in preferred provider networks, the most common type of health plan, has risen to $10,217, with employees paying $2,691 of the total. In response to the soaring costs, many small companies are simply no longer offering coverage of a worker's spouse and children."

Mortgage Finance Bubble Watch:

September 10 - Countrywide Financial: "Monthly purchase activity rose for the six consecutive month to $18 billion, an increase of 1 percent over last month and 42 percent more than August 2003. Year-to-date purchase volume now stands at $113 billion, approaching 2003's full year level of $130 billion... Adjustable-rate fundings reached a record $18 billion, (up 7% from July and) 83 percent greater than August 2003, and accounted for 59 percent of total month loan volume... Home equity funding sreached a new monthly record of $3.1 billion, 8 percent more than the previous month and 80 percent higher than August 2003. Year-to-date home equity production surpassed $18 billion, and exceeded the volume achieved in calendar 2003. Subprime volume grew for the month to $4.3 billion, advancing 13 percent from last month and increasing 158 percent over August 2003." Total August fundings of $31 billion were up 5 percent from July, with y-t-d fundings of $237 billion. "Total assets at Countrywide Bank rose to $31 billion, 8 percent higher than July 2004 and double the level of August 2003."

September 9 - Bloomberg (Kathleen M. Howley): "U.S. mortgage delinquencies rose last quarter for the first time in a year while foreclosures fell to the lowest level since 2000, according to a Mortgage Bankers Association report. The share of homeowners who paid their mortgages a month or more late rose to a seasonally adjusted 4.43 percent, from 4.33 percent in the first quarter... The share of loans in foreclosure fell to 1.16 percent from 1.27 percent in the prior quarter."

Bubble Bubble Mortgage Trouble:

I wrote an article for the the Summer 2004 edition of The International Economy, an excellent publication that I strongly recommend. They passed on my suggested title, The Great Mortgage Finance Bubble, but theirs will have to do.

Back in 2000, I wrote an article for The International Economy titled "The Great Experiment." The focus of the analysis was the nuances of contemporary finance, in particular the ramifications for unchecked growth from the government-sponsored enterprises (GSEs). Four years later, sufficient data and observations from this "experiment" warrant an update and further analytical examination.

From January 2000 through May of this year, Fannie Mae and Freddie Mac's combined "books of business" (retained portfolios and guaranteed mortgage-backed securities sold into the marketplace) have ballooned 77 percent to $3.66 trillion. Fannie and Freddie total assets have increased 186 percent to $2.83 trillion since the beginning of 1997, with Federal Home Loan Bank System assets up 193 percent to $857 billion. And according to Federal Reserve "flow of funds" data, total mortgage debt has increased 93 percent to $9.62 trillion, jumping from 61 percent to 84 percent of GDP in seven years.

Total mortgage borrowings expanded $1.0 trillion or 12 percent last year, with 2004 on track to surpass 2003's record. For comparison, mortgage debt increased on average about $200 billion annually during the first eight "pre-bubble" years of the 1990s. Total U.S. home sales are currently on track to surpass last year's record by 10 percent, with the dollar value of housing transactions up approximately 65 percent over three years and 100 percent from six years ago. The nation's average (mean) price of existing homes sold has increased 28 percent over three years and 48 percent over the past six years. In California, median home prices were up an astonishing $97,530 during the past twelve months (through May) to $465,160. Golden State home prices have surged 46 percent over two years, 81 percent over three years, and 129 percent over six years, in what has developed into one of history's spectacular asset inflations.

The GSEs have played the instrumental role in the development of a historic mortgage finance bubble. And while the GSE debate tends to concentrate narrowly on the values of the federal subsidy and the implicit government backing of agency debt, the broader - and crucial - issue of the consequences of a momentous expansion of mortgage finance is neglected, if at all recognized.

Reminiscent of the late-1990s manic stock market environment, the issue "Is housing a bubble?" has become a hot topic for the media, investment analysts, economists, and policymakers. Federal Reserve Bank of New York economists Jonathan McCarthy and Richard W. Peach recently published "Are Home Prices the Next 'Bubble'?" This research suggests that, in spite of significant attention directed to the issue of asset bubbles, our central bank has made scant progress in comprehending or addressing either asset inflation or bubble dynamics.

Messrs. McCarthy and Peach concluded that "there is little evidence to support the existence of a national home price bubble." Yet, their article - and Federal Reserve research generally - ignores what should be the focal points of bubble analysis: credit growth, speculative finance, marketplace liquidity, and various financial and economic distortions.

Analyses of the GSEs and mortgage finance should begin with an appreciation for the extraordinary capacity of key lenders these days to issue unlimited quantities of new liabilities (chiefly, agency and asset/mortgage-backed securities) with no impact on the market's perception of these instrument's "Triple-A" quality status. Indeed, it is a defining characteristic of contemporary Wall Street "structured finance" that virtually inexhaustible quantities of risky loans can be transformed into perceived top-quality, safe and liquid securities. This alchemy is dependent upon a daisy-chain of explicit and implicit guarantees, credit insurance, liquidity agreements, and the expansive derivatives marketplace. The GSEs are very much the nucleus, while the market's faith in the Fed and Treasury to stand behind Fannie, Freddie, and the FHLB provides the backbone of this peculiar market structure.

From a theoretical perspective, financial evolution has attained a renown I will refer to as the "moneyness of credit" - a pinnacle achievement conceptually and an unexplored quandary in reality. Throughout history, faith in the relative safety of fiat money has left it inherently susceptible to over-issuance. And with the creep of monetary inflation comes the specter of myriad inflationary effects, currency debasement, and progressive monetary disorder. These days, GSE and Wall Street securities fabrication has supplanted the government printing press as the paramount source of monetary inflation. Total "structured finance" - combined GSE assets, along with outstanding mortgage and asset-backed securities - has over seven years mushroomed an astonishing 126 percent to $7.46 trillion.

Traditionally, bank lending to fund business spending and investment provided the predominant source of finance. In the process, bank loans expanded the money supply through the creation of new bank liabilities/deposits. But no longer do banks and their deposit "money" hold sway over either the financial system or economy.

Financial systems have evolved profoundly. Especially over the past decade, this evolution has radically altered the character of lending and intermediation, along with the types of financial sector (in contrast to bank) liabilities issued. Importantly, non-bank asset-based lending is today the commanding mechanism, creating the liquidity that drives both financial markets and economies.

Total "structured finance" has jumped from 41 percent to 65 percent of GDP in just seven years. During this period, total bank loans and leases rose from 35 percent to 40 percent of GDP, expanding 60 percent to $4.54 trillion (real estate loans accounting for two-thirds of bank loan growth). Examining the nature of lending, it should be clear that contemporary "money" is today increasingly comprised of agency securities and agency-related instruments, along with Wall Street structured products. "Money" is big business.

It is worth emphasizing the current historical anomaly that, domestically as well as globally, there is no mechanism, effort, or regulatory mandate to control either the quantity or the quality of contemporary money and credit expansion. As such, I would argue that there is today an overriding top-down predicament associated with contemporary finance: There exists a powerful dual capacity and propensity for debt to be issued in excess by myriad profit-seeking financial intermediaries. What's more, seemingly limitless profit potential will ensure that asset markets - both real and financial - will attract the lion's share of lending and finance. How can a limited universe of profitable investment opportunities compete for lender enthusiasm against those available from bountiful - and inflating - asset markets?

Throughout the lending process, the preponderance of financial-sector liabilities created - contemporary money and credit - will be perceived to be of the highest quality and liquidity. This "moneyness" attribute predicates virtually insatiable demand for the underlying debt instruments, which impels lending excess, over-issuance and self-reinforcing asset inflation.

Such inflation provides a boon to enterprising speculators, also enjoying unparalleled access to finance as they play a decisive part in advancing self-reinforcing asset bubbles. Mortgage finance bubble analysis includes two distinct facets of asset speculation: Exuberant borrowing to finance home and property purchases, as well as aggressive speculator leveraging in agency and mortgage-backed securities. "Speculator" in this context would include the expansive hedge fund community, securities broker/dealer proprietary trading, mutual funds, banks, insurance companies, corporate finance departments, pension funds, and various individuals and institutions (domestic and international) employing "carry trades," "repos," derivatives, and myriad leveraged strategies. Evolving insidiously over time, the liquidity created in the process of leveraged asset speculation emerges as a governing source of finance for both the markets and the general economy - i.e., the 1990s tech/telecom bubble and today's housing/consumption bubble. To ignore asset inflation, speculative finance, and bubble dynamics is really to disregard the very essence of contemporary finance and economics.

The GSEs have enjoyed virtually unbounded capacity to finance expanding asset holdings through the issuance of perceived risk-free liabilities. Their liquidity-creating powers have on numerous occasions proven invaluable in ameliorating acute systemic stress. In reality if not by statute, the GSEs evolved to attain the all-powerful status of quasi-central banks. Their aggressive expansions during the 1994 bond market dislocation, the 1998 Long-Term Capital Management debacle, the 1999 Y2K scare, and the tumultuous 2000-2002 period were certainly invaluable in rectifying jeopardous market conditions.

Chairman Greenspan often asserts that the U.S. economy's ability to persevere - and indeed excel - despite a series of shocks and setbacks is largely attributable to its extraordinary "productivity" and "flexibility." Yet a strong case can be made that any accolades should be directed foremost to the Herculean resiliency of contemporary finance.

Above all, abundant and unabated credit and liquidity creation fueled home price inflation. The Federal Reserve collapsed rates and orchestrated a steep yield curve that, along with assurances of liquid financial markets, incited unparalleled leveraged speculation. Truly unprecedented system credit expansion underpinned buoyant asset markets: From the household and government sectors, on the one hand, and financial sector leveraging on the other. And asset inflation was certainly instrumental in stimulating demand to sustain the consumption and services-based American economy.

There is another critical facet to GSE market power and influence that goes unappreciated. As quasi-central banks intervening to stabilize the U.S. credit market, Fannie and Freddie have attained the prominence of "buyers of first and last resort" for speculators leveraged in mortgage-backed and other debt securities. Repeated aggressive market interventions over the years were instrumental in averting dislocations, and in the process enriched and emboldened the speculating community. Why not take full advantage of a steep yield curve by leveraging mortgage securities when Fannie and Freddie stand ready to aggressively purchase these holdings in the event of unfolding market stress? GSE market influence has been instrumental in nurturing the hedge fund and proprietary trading communities, and with them the ballooning global pool of speculative finance.

Furthermore, the GSE's aggressive securities purchases - at critical junctures circumscribing interest-rate spikes and dislocation otherwise associated with speculative de-leveraging - have played a definitive, yet surreptitious, role in the explosion of derivative positions. Here as well, the GSE liquidity backstop has emboldened risk-taking and distorted the marketplace. The viability of much of the derivatives marketplace rests on the assumptions of continuous and liquid markets - specious premises thus far affected legitimate by unending and timely GSE expansion.

Mushrooming derivatives markets have, in turn, played an instrumental role in the historic ballooning of GSE and mortgage debt generally. The GSEs have accumulated more than $1 trillion of short-term debt, while relying extensively on derivatives to hedge a potentially catastrophic asset/liability mismatch. On one hand, GSE interventions underpin marketplace liquidity. On the other, the GSEs and mortgage-backed securities holders are the largest buyers of derivative protection. Meanwhile, GSE counterparties rely predominantly on dynamic hedging strategies, with computer hedging models calculating the quantities of securities to buy or sell in the event of changing interest rates.

The major problem is that the larger GSE balance sheets, mortgage debt, speculative leverage, and derivative positions balloon, the less viable this entire hedging ("portfolio insurance") mechanism becomes. It is simply not feasible for a large segment of the marketplace to move concurrently to hedge exposure in a rising rate environment. After all, marketplace liquidity would be inadequate to accommodate the enormous hedging-related selling into a faltering market. Moreover, rapidly rising rates render derivative traders and leveraged players increasingly aggressive sellers, competing for limited and waning liquidity. I am therefore left with the disconcerting view that the GSEs have evolved into the linchpin for a massive mortgage finance bubble encompassing endemic - and eventually untenable - financial sector leveraging, speculating, and derivative trading.

Yet the ramifications of the mortgage finance bubble are anything but confined to the financial arena. Indeed, the bubble's effects on the real economy may very well prove the most intractable. Mortgage credit excess and asset inflation today foster household over-borrowing and over-consumption. Investment decisions are similarly distorted. About two million residential units will be constructed this year, approximately 45 percent higher than the 1990s average of 1.37 million. The ongoing multi-year construction boom also includes retail, restaurant, hotel and gaming, sports venues, and other consumption-related structures. Regrettably, we are witnessing a replay of the late-1990s telecommunications and technology boom-and-bust experience, where a surfeit of speculative finance fosters destabilizing over-spending in the "hot" sectors.

It is the very nature of speculative finance that inflated boom-time profits seductively induce only greater speculative flows, and in the process evoke notions of New Eras and New Paradigms. The destabilizing torrent of finance assures systemic vulnerability to the inevitable reversal of speculative flows (i.e. the tech bubble's stock and junk bond boom and collapse), exposing the extent of previous uneconomic investment. The abrupt adjustment of distorted boom-time spending patterns proves especially destabilizing - most economic agents are caught heavily exposed and flat-footed after extrapolating the boom far into the future. Bursting bubbles also invariably uncover significant waste and fraud. Indeed, a confluence of factors is set in motion that rectifies the divergence between perceived financial wealth and true economic wealth that had become so distended during the maniacal phase of the boom.

Today, the size of the pool of speculative finance is significantly larger than what fueled the tech bubble just a few short years ago. The housing and the consumer sectors have become the magnets for truly momentous financial flows. Asset inflation and associated spending and investment have evolved to become the driving force behind heady household income growth (rising at a 6.7 percent rate year-to-date through May!). And recalling how inflated boom-time technology profits were extrapolated to justify gross equities overvaluation (as well as over-borrowing), inflated household income growth is these days used to assert the reasonableness of both inflated housing values and surging consumer debt loads. A pernicious circularity is a work here, as sufficient purchasing power to sustain inflated asset prices and an unbalanced economic expansion is generated only through unrelenting and enormous mortgage borrowings.

Bubble excesses, including over-consumption and maladjusted investment, have engendered an increasingly untenable trade position. Unrelenting U.S. current account deficits beget dollar weakness and a swelling pool of global dollar liquidity. Yet one is hard-pressed to glean analysis linking the GSE and mortgage finance bubbles to ballooning U.S. foreign liabilities and destabilizing global "hot money" flows. No less an authority than Alan Greenspan proclaims confidence that the market pricing mechanism will function over time to innocuously rectify U.S. imbalances.

Analysis of the nature of bubble dynamics, however, leaves one anything but complacent. Categorically, asset bubbles require ever-increasing quantities of credit expansion. As for housing, rising borrowings are necessary to finance booming transaction volume and maintain inflated values. This is most conspicuous currently with the hyper-bubble markets in California and along the East Coast. And liquidity emanating from the mortgage finance bubble these days fuels inflated and vulnerable financial asset prices. There is, as well, the critical issue of bubble economies, prolonged only by escalating credit creation. The consumption, services, and finance-based U.S. bubble economy - with huge trade deficits, scores of uneconomic enterprises, and myriad general imbalances - is an absolute credit and liquidity glutton.

Importantly today, inflating asset markets have evolved to become the key mechanism for generating liquidity and income growth system-wide, rendering the entire financial and economic system acutely vulnerable to any diminution of credit growth.

Current complacency is understandable. The U.S. economy has indeed overcome a series of shocks. Presuming that technology and the stock market were the bubble, the consensus view trumpets the resiliency of the "post-bubble" U.S. economy. The harsh reality, however, is that the tech and equity boom was only an appendage of a mammoth bubble progressing uninhibited throughout the U.S. credit system. Today, I would strongly argue that the credit bubble is in the midst of its "terminal" stage of excess. Credit inflation manifestations have turned increasingly destabilizing and difficult to manage.

It is worth contemplating that from the late 1990s through 2001, the U.S. economy and markets were the favored destination for global investors and speculators. The "king dollar" period was anomalous for the ease with which escalating U.S. current account deficits were recycled back to American assets. There have been, however, some rather momentous changes over the past couple of years. Not only have U.S. current account deficits ballooned to historic extremes, investor and speculator funds now flow enthusiastically to various non-dollar markets and asset classes. The environment for recycling dollar balances has abruptly inverted from extraordinarily favorable to increasingly problematic.

Our nation's annual current account deficit is approaching $600 billion. The dollar has suffered a sharp two-year decline against the euro and most major currencies, with the dollar index sinking 25 percent since 2002's first quarter. Arguably, only unprecedented central bank dollar purchases have extricated currency markets from the scourge of illiquidity, dislocation, and crisis. Global central banks expanded international reserve assets by approximately 27 percent the past year to $3.25 trillion, with the major Asian central banks increasing largely dollar reserves in the neighborhood of $545 billion, or 38 percent, to $1.97 trillion.

The consequences of this unparalleled monetary inflation include an unwieldy boom in China and throughout Asia, rising global energy demands and prices, manic commodities markets with examples of depleting inventories, and generally heightened price pressures globally. Importantly, the global pricing environment has been transformed from "dis-inflationary," to "re-flationary," to the current distinctly inflationary. There is today, then, the issue of the consequences of open-ended massive foreign central bank dollar support and monetization. Going forward, central bankers will have no alternative than to weigh the competing risks associated with ongoing dollar support and resulting inflationary effects, versus a faltering dollar, unstable currency markets, and U.S. financial and economic fragility.

I made the case four years ago that uncontrolled GSE excess posed a threat to our policymakers' strong dollar policy. I today advise that the U.S. mortgage finance bubble creates a clear and present danger to the stability of our financial system and economy, as well as the soundness of our currency.