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The Fun is Gone From the Game of Risk

Household International

It was another wild one, with heightened fears of company financing problems creating a most unsettled market environment. Despite today's big rally, the Dow and S&P500 ended the week with declines of about 2%. The Transports were hit for 4%, the Utilities 3%, the Morgan Stanley Cyclical index 2%, and the Morgan Stanley Consumer index lost 1%. The broader market was under selling pressure also, with the small cap Russell 2000 dropping 3% and the S&P400 Mid-Cap index declining 2%. Technology stocks came under heavy liquidation, with the NASDAQ100 and Morgan Stanley High Tech indices dropping 5%, and the Semiconductors 4%. With cash flow problems a top concern, The Street.com Internet and the NASDAQ Telecommunications indices were clobbered for about 10%. The biotechs generally dropped 4%. Financial stocks rallied strongly today, but for the week the AMEX securities broker dealer index declined 2% and the S&P Bank index dipped 3%. With bullion surging $17.60, the HUI Gold index jumped 11% this week.

The Credit market trades nervously, with considerable volatility throughout the corporate and agency sectors. Treasuries benefited from the increasing tumult, as 2-year yields declined 15 basis points to 2.78%. Five-year Treasury yields declined 12 basis points to 4.17% and 10-year yields dropped 7 basis points to 4.91%. The long bond saw its yield decline 2 basis points to 5.37%. Mortgage-back and agency yields ended the week down about 7 basis points. The spread on Fannie Mae 5 3/8% 2001 bond widened 5 to 71, while the 10-year dollar swap spread widened 3.5 basis points to 75.5. The dollar index suffered a marginal decline.

Feb. 4, National Association of Realtors - "Sales of existing condominiums and cooperatives set a sixth consecutive annual record in 2001, although sales eased in the fourth quarter from an all-time high in the third quarter… Condo and co-op resales totaled 738,000 in 2001, up 3.8 percent from the previous record of 711,000 sales recorded in 2000… The median existing condo price for 2001 was $122,600, up 9.7 percent from $111,800 in 2000. During the fourth quarter, the typical condo price was $125,000, which is 9.8 percent higher than the same quarter in 2000."

"The ABS market got off to a roaring start in 2002, with $27.8 billion issued in January. This is the fastest start that the ABS market has had out of the gate, and the sixth heaviest issuance month ever. The heaviest new issue month was March 2001, with $33 billion of US public ABS brought to market. Not too surprisingly, the asset classes most prominently represented in January were auto and home equity loan ABS. These two sectors brought to market $12.6 billion and $8.3 billion, respectively, in January… As for the home equity loan sector, we are looking for new supply to reach $100 billion this year." Morgan Stanley

Broad money supply increased almost $13 billion last week, with institutional money fund assets increasing $4.5 billion, large time deposits $6.7 billion, and repurchase agreements $4.4 billion. Retailers' January same store sales rose at a better than expected rate of 5.2%, the strongest gain since April 2000. Wal-Mart's 8.6% same store sales gain was above expectations, with total January sales of $15.4 billion up 13.9% from last year. The Mortgage Bankers Association's weekly index of mortgage purchase applications increased almost 4%, and was up 9% year over year. After rising $20 billion during November, December consumer credit declined by $5 billion.

I will again this week highlight the analysis of eminent economist Milton Friedman. I must admit to being rather fascinated with his work. Throughout his career he has been a diligent monetary historian and prolific writer, and we do share his distrust for government monetary "fine tuning," as well as his appreciation for the danger of concentrated financial power. The first quote I am in agreement with, but I then follow with his analysis of causes of The Great Depression and his fixation with narrowly defined money (at the expense of a much more valuable comprehensive view of Credit and its effects) that we are very much in disagreement. From my research, I can find no one individual whose work has had greater influence on the essence of contemporary monetary policy or on the marketplace's perception of the efficacy of central banking.

"The lesson I draw from this brief survey of history is that the major problem is how to avoid major mistakes, how to prevent such a concentration of power in a small number of hands that that group can make a major mistake. The great virtue of a decentralized system is that mistakes average out. If one unit does something wrong, it does not have a wide effect. If the power is centralized, there is a great deal of power to do harm. The problem is how to erect a system which will have the effect of reducing the power for harm without unduly reducing the power for good, and which will provide a background of monetary stability." Milton Friedman, A Program for Monetary Stability, Readings in Financial Institutions, 1965, p. 201-202

"The stock market boom and the afterglow of concern with World War I inflation have led to a widespread belief that the 1920's were a period of inflation and that the collapse from 1929 to 1933 was a reaction to that. In fact, the 1920's were, if anything a time of relative deflation: from 1923 to 1929 - to compare peak years of business cycles and so avoid distortion from cyclical influences - wholesale prices fell at the rate of 1 per cent per year and the stock of money rose at the annual rate of 4 per cent per year, which is roughly the rate required to match expansion of output. The business cycle expansion from 1927 to 1929 was the first since 1891-93 during which wholesale prices fell, even if only a trifle, and there has been none since. The monetary collapse from 1929 to 1933 was not an inevitable consequence of what had gone on before. It was a result of the policies followed during those years.alternative policies that could have halted the monetary debacle were available throughout those years. Though the Reserve System proclaimed that it was following an easy-money policy, in fact it followed an exceedingly tight policy." Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States 1867-1960, 1963, p. 699

"The question would remain whether the monetary changes were the inevitable result of the economic changes, so that, if the [Federal Reserve] System had not been the intermediary, some other mechanism would have enforced the same monetary changes; or whether the monetary changes can be regarded as an economically independent factor which accounted in substantial measure for the economic changes. There is little doubt about the answer. At all times throughout the 1929-33 contraction, alternative policies were available to the System by which it could have kept the stock of money from falling, and indeed could have increased it at almost any desire rate. Those policies did not involve radical innovations. They involved measures of a kind that System had taken in earlier years, of a kind explicitly contemplated by the founders of the System to meet precisely the kind of banking crisis that developed in late 1930 and persisted thereafter." p. 693

"The issue that has perhaps received the most attention centers on the reason for the bank failures. Did they arise primarily from the financial practices of the preceding years? Or were they produced by the developments of the early thirties? Even if the first view were correct, the indirect monetary consequences of the failures are separable from the failures as such and need not have been also the near-inevitable consequences of the developments of the twenties." p. 353

"…there is some evidence that the quality of loans and investments made by individuals, banks, and other financial institutions deteriorated in the late twenties relative to the early twenties… The evidence for such deterioration is fully satisfactory only for foreign lending. For the rest, the studies made have not satisfactorily separated, and some have not even recognized, the difference between the ex ante deterioration…and the ex post deterioration that occurred because the loans and investments came to fruition and had to be repaid in the midst of a major depression… Indeed, many of the results are consistent with no deterioration at all in ex ante quality. If the evidence is unsatisfactory for loans and investments in general, it is even sparser and more unsatisfactory for the loans and investments of commercial banks in particularIf there was any deterioration at all in the ex ante quality of loans and investments of banks, it must have been minor, to judge from the slowness with which it manifested itself." p. 354

"I think that I was right, that as of that time and as of today, the American economy is depression proof. The reason I gave at that time did not include the fact that discretionary monetary and fiscal policy was going to keep things on an even keel. I believe that the reason why the world has done so much better, the reason why we haven't had any depression in that period, is not because of the positive virtue of the fine tuning that has been followed, but because we have avoided the major mistake of the interwar period. Those major mistakes were the occasionally severe deflation of the money stock. We did learn something from the Great Depression. We learned that you do not have to cut the quantity of money by a third over three or four years." Milton Friedman, Monetary vs. Fiscal Policy, 1969

"Central Bankers, like other students of money, have learned this lesson, which is part of the reason that there has been no repeat of the Great Depression in the post-World-War II period despite repeated scares. The Federal Reserve under Alan Greenspan is currently applying that lesson, which is reason to believe that the current recession will be mild and that expansion will soon resume." Milton Friedman, The Wall Street Journal, January 22, 2002

Yes, students of money have been taught lessons from the Great Depression, we only argue that these teachings and analyses have been radically flawed. Many have argued - as Dr. Friedman has with regard to the 1920s - that the past decade has been a period of "relative deflation." Dr. Friedman wrote recently in the WSJ that "the quantity of money" expanded at a "4.1% per year from 1990 to 2000," which was only slightly above the 3.9% annual increase he quoted from the Twenties. I must assume - and it would certainly be consistent with his analysis - that this calculation for the '90s was on some narrow definition of money (that he should have identified). I calculate M3 growth at 6.8% annually for the decade, although I hasten to add that during the critical six-year period 1996 through 2001 broad money supply expanded 77% (10% annualized) to surpass $8 trillion. There is, moreover, a critical bone of contention regarding what actually transpired within monetary systems during the Twenties and Nineties that goes right to the heart of incredibly misguided conventional doctrine.

To better appreciate what proved a very fragile financial and institutional structure that developed throughout the Twenties (and earlier), let's dig through some data from Raymond W. Goldsmith's seminal work, Financial Intermediaries In the American Economy Since 1900, published in 1958. Between 1922 and 1929 total assets of the banking system expanded 5% annualized to almost $82 billion. With our determined "sectoral" approach to analyzing financial sector assets, we see that "loans for carrying securities" increased at an almost 13% annual rate to $8.3 billion, while non-real estate loans to households increased at an almost 12% pace. "Commercial and industrial loans" expanded at less than 2% annually, while loans to farmers (back when agriculture remained a meaningful part of the economy) actually declined at about a 3% rate. This data confirm the important fact that monetary processes within the banking system had shifted to financing consumption and speculation, which is perfectly consistent with the deflationary bias prevalent in the commodities and goods markets.  The critical monetary effect was apparent with inflationary pressures bubbling in asset markets, as well as the consequent distortions to the economy's structure of demand.

And, importantly, over this period total financial intermediary (banks, insurance companies, brokers, saving & loans, etc.) assets increased at an 8% annualized rate to $167 billion (up from 1912's $40.8 billion). Insurance company assets expanded by 11% annually over seven years, as the banking system's share of total financial intermediary assets declined from 60.4% to 48.9%. "Miscellaneous Financial Intermediaries and Personal Trust Department" assets doubled over seven years to $45.4 billion. "Security brokers and dealers" assets were estimated to have grown at a 14% annualized rate to $10 billion. "Total Nonfarm Residential Mortgages" expanded at a 13% rate over these seven years to $27 billion. "Domestic Corporate Bonds Outstanding" increased at about a 7% annualized rate to $39 billion, while the total value of marketable equities outstanding surged at a 14% rate to $147 billion (before collapsing back to about 1922's level to end 1933 at $62.5 billion). The total estimated value of "National Assets" (tangible, claims and total equity value of incorporated businesses) increased 50% over seven years to $982 billion.

I went into this level of detail to hopefully elucidate that there was an extraordinary inflation in financial claims throughout the1920s, with extreme Bubble characteristics in the final years of the decade. There was, as well, dramatic sectoral divergence within the financial sphere commensurate with the state of flux imparting distortions and imbalances throughout the real economy. Unsound monetary processes had developed - within the context of momentous technological innovations and financial experimentation - that were fueling unsustainable asset inflation and major distortions in income growth and the overall character of spending. A myriad of new financial institutions and structures gained prominence in financing consumption, speculation, and asset markets generally. It should be obvious that Dr. Friedman's focus on the decade's 3.9% money supply growth is woefully superficial and inadequate analysis. Furthermore, his contention that such an historic Bubble could have been largely mitigated by Federal Reserve money supply creation is highly suspect, to say the least.

Nonetheless, this historical revisionism obviously struck quite a cord over the past forty years. Who, after all, would not want to believe that such an historic boom was sound and that only policy failed? How alluring it is to hear that there were no weaknesses or vulnerabilities in the market mechanism, only a handful of incompetent central bankers! So not only have we watched the Federal Reserve nurture a similar Bubble over the past decade, we have over the past year witnessed the Fed frantically accommodate an unprecedented $1 trillion money supply expansion and ignore conspicuous Credit and speculative excess. Dr. Friedman's analytical footprints are all over such policies past and present, while he and conventional economists today view the Fed as successfully and appropriately "applying [the] lesson" learned from the early 1930s policy failure. Our view simply could not be more diametrically opposed, believing there has been a momentous misdiagnosis of the ailment, with the prescription of only stronger poison. While admitting there were surely post-Twenties Bubble policy misjudgments, this does not at all alter the true causes of the Depression. A difficult and protracted adjustment period was unavoidable after years of excess, a massive accumulation of financial claims, and extreme distortions to the structure of the U.S. and global economy. It is a disservice to the public interest that such obvious analysis is to this day seen as economic heresy. I provide this rehash specifically because I believe this momentous 70-year or so analytical and intellectual battleground will be resolved in the not too distant future, and I don't expect conventional doctrine to retain its reign over public and marketplace perceptions.

These are truly irreconcilable views, and how this is resolved will have major ramifications. On one side, we have those with faith that the Greenspan Fed is at the top of its game, that the basic underpinnings of the economy and financial system are sound, and that the Fed is well into successfully commanding the healing process. One the other side are those of us sternly convinced the Fed is perpetuating an historic policy disaster as it only further accommodates a precarious inflation of suspect financial claims and potentially catastrophic financial and economic maladjustments. A much more arduous and uncertain adjustment process is only being postponed. In short, the Fed is "betting the ranch." Inarguably, the Fed has moved with full force to aid the system, and there is today unstinting confidence of its success. We therefore see a marketplace and financial system extraordinarily ripe for disappointment and a serious breach of confidence. What is left if faltering markets demand an encore - yet one more round of reliquefication?

This week I find Dr. Friedman's doctrine especially provocative and regrettably pertinent. For one, he dogmatically disregards total financial claims and, therefore, discounts related financial and economic maladjustments. Apparently, no malady is immune to Fed money creation, seeing money supply growth as an integral part of the solution. I believe that total financial claims provide a much better gauge of distortion inducing Credit excess and financial fragility, encompassing the key but unfortunately nebulous concept of institutional debt structures. Additionally, it is the U.S. financial sector (not the Fed) that today plays the critical role in money creation. Contemporary money supply expansion should be viewed within the context of the intermediation of risk - the transformation of risky loans into perceived "safe" money. Any interruption in this intermediation process will bring this protracted period of rampant money supply expansion to a conclusion, with enormous consequences. Money is a residual to the Credit creation process, and certainly not the cure of our system's deep structural problems.  Yes, the Fed can continue to accommodate the wholesale creation of additional financial claims but if these claims are unsound - not backed by true wealth creating capacity - this only augments the vulnerability of our financial intermediaries.

And while I continue to be amazed that, especially considering the unfolding circumstances, our viewpoint would be deemed "extremist," perhaps it comes back to Dr. Friedman's very questionable assertion that the quality of loans and investment did not suffer at the late stages of the Twenties' Bubble. It is a central tenet of Credit Bubble analysis that risk grows exponentially during the "terminal stage" of Bubble excess (larger quantities of increasingly deficient debt, generally financing over consumption, speculation and asset inflation), a harsh reality that completely invalidates conventional policy prescriptions. It is today obvious that the quality of the huge amount of additional Credit creation necessary to keep this maladjusted Bubble economy levitated is a disaster for a U.S. financial sector that is forced to intermediate much of this risk. It appears the marketplace is finally beginning to come to this realization.

In this context, we had two major developments this week. First, we have a major company (Tyco) apparently experiencing difficulty rolling its commercial paper. Over six sessions, the spread on Tyco bonds blew out 300 basis points to 430. Second, we have heightened concerns within the Bush administration that GSE debt growth is out of control and their derivative activities an increasing systemic issue. These developments are getting too near the U.S. Credit system's jugular for comfort.

At the minimum, we've passed a critical inflection point in the unfolding financial crisis, with the U.S. corporate bond market moving toward dislocation. It is today fair to say that this unavoidable predicament was only delayed by last year's extreme Fed accommodation and massive GSE-led reliquefication. This "respite" has come to an abrupt conclusion. It now appears the commercial paper market is closing down for many, including major borrowers such as Tyco. I don't think we can overstate the importance of such a circumstance. Throughout the corporate bond market spreads have widened, in many key instances dramatically. We've reached a point where this is very much a systemic issue impacting some of the largest corporate borrowers including Tyco, Household International, WorldCom, Williams Companies, as well as a bevy of others including Motorola and Calpine (naming just a few).

In our efforts to analyze how this might unfold, it is today helpful to think in terms of contemporary financial crises. Recalling back to 1997/98, the collapse in Thailand set off a chain reaction of crises throughout the region. This contagion (that caught conventional analysts completely flatfooted) is easily explained by the complex daisy chain of leverage, derivatives, and endemic speculation, as well as the consequent fragile financial structures and economic maladjustments. I am, however, increasingly of the view that the Argentine debt crisis provides a much cleaner analytical comparison to the unfolding U.S. debt crisis.

Importantly, the domestic Argentine monetary backdrop and global financial dynamics created a magnet allowing the accumulation of massive financial claims of increasingly suspect quality. Concurrently, the derivatives market provided an expedient guise of a true market for insurance against currency, interest rate, and default risk. As long as additional liquidity flowed into the marketplace, such risks appeared miniscule and insurance remained readily available. As we have tried to explain ad nausea, the confluence of speculation both in the underlying debt securities and in writing derivative insurance fostered a self-reinforcing Credit Bubble. Again, the system functioned with all appearances of soundness and sustainability as long as sufficient injections of additional liquidity were forthcoming. The supply of inexpensive derivative insurance seemed endless, which only exacerbated the speculative Bubble.

However, when these flows eventually reversed, (in true musical chairs fashion) there was a mountain of acutely vulnerable financial claims and a corresponding interest rate, Credit, and currency derivative quagmire. The seductive illusion of virtuous circle was transposed to the ugly reality of vicious financial death spiral.  And while the timing remained uncertain, Credit Bubble analysis made it perfectly clear that financial collapse was unavoidable. With the first sign of outflows and faltering bond prices, the writers of the derivative insurance (with their dynamic hedging strategies) then became bond sellers. This was necessary to establish the short positions to generate the cash flows to make good on developing marketplace losses. These dynamics ensured illiquidity and market dislocation, sparking frantic demand for default and currency protection. On the surface this situation may have appeared manageable, but in the murky world of contemporary finance a dislocation in the underlying market for risk made collapse a virtual foregone conclusion. The disappearance of liquidity in the Argentine debt market, and the consequent economic suffocation, clinched an eventual run on the currency and the breakdown of the vaunted currency board regime. Unavoidable devaluation would then necessitate massive derivative related selling, with "insurers" forced to dynamically hedge ballooning exposure. The domestic financial intermediaries were doomed.

The nature of Argentina's collapse is troublingly consistent with the long string of financial crises experienced over the past eight years. The only perplexing aspect of this extraordinary environment is that such dynamics are not recognized as specifically related to a dysfunctional global financial architecture, endemic leveraged speculation, and related acutely fragile debt structures. It is now my view that the U.S. corporate bond market has firmly entered a most crucial stage, with speculative flows having reversed and market dynamics irreparably altered. Again, this outcome was only postponed by the aggressive actions of the Fed and GSEs. Importantly, forced selling (shorting) of corporate bonds and related instruments has become a key factor exacerbating faltering liquidity. During the corporate debt Bubble - that generally flourished until recently - Credit insurance, default swaps, liquidity arrangements, and the like played an integral role in inciting self-feeding speculative flows (domestic and international) into corporate debt securities, structured instruments and vehicles. Today, "virtuous" circle is in the process of turning vicious cycle, as faltering illiquidity necessitates more derivative-related selling in self-reinforcing market dynamics. The risk market is in dislocation.

Household International provides an excellent case in point. The spread on its 6 3/8% 2011 bonds has widened 80 basis points to 246 during the past nine sessions. The company and Wall Street assured the markets that its accounting is fine, with the company pinpointing "hedge fund" shorting as responsible for its sinking bonds. The company also denied rumors that it has experienced problems issuing commercial paper. Well, this is a company with $85 billion of assets ($100.8 billion managed portfolio of largely consumer loans) and $9.3 billion of shareholder's equity. It has a significant portion of its assets in subprime loans. Providing a hefty spread to Treasuries, its bonds would have certainly been enticing fodder to those leveraging in "spread product." Today, however, with the consumer Credit Bubble at the precipice and the subprime boom turning bust, Household debt would be precisely where we would expect selling - at the margin. At September 30th, the company had $53 billion of long-term senior and subordinated debt, with $11 billion of commercial paper and bank borrowings, billions of receivables sold into the marketplace with some recourse, and significant derivative exposure. Subsequent derivative-related selling would only compound the liquidity problem set in motion by a flight away from Household debt, with nervous players scrambling to avoid the next falling domino. And, as Providian is experiencing (yesterday reporting a $395 million loss and its "net Credit loss rate" jumping from 10.47% to 12.23% during the quarter!), when an aggressive lender loses access to finance and is forced to limit its customers' access to additional borrowing, the vicious spiral scenario is unleashed.

Household Int. debt problems are noteworthy on several levels. It is clearly an important escalation, along with Tyco, from the market's issue with the cash strapped telecom (Global Crossing, WorldCom, Williams Companies, etc.), airline, and energy sectors, as well as other (Kmart!) negative cash flow businesses. Also keep in mind that Household is a prime example of the type of Credit creation aggressively accommodated by the Fed over the past year, with managed receivables growing at a 22% rate during the fourth quarter and 15% during the year. We certainly view Household liquidity concerns in the context of an important deterioration in the general liquidity environment, and indicative of critical developments unfolding for the vulnerable Consumer Bubble. It appears at this time that the noose is getting tighter around the neck of the aggressive consumer lenders (evidenced by recent stock weakness for Capital One, AmeriCredit, Metris, MBNA, etc.). This signals a major escalation in the unfolding debt crisis. This afternoon S&P revised its outlook for Metris and Capital One debt to negative from stable.

Liquidity concerns at Household and Tyco's difficulties in the commercial paper market also signal that liquidity issues are coming disconcertingly close to the asset-backed marketplace. This crisis does appear increasingly to have a bead directly on "structured finance," a marketplace that by default became the critical epicenter of U.S. financial system liquidity. Today's New York Times' revelation that Citigroup successfully hedged against its Enron exposure by creating and selling structured instruments is worthy of comment. In Citigroup's largest transaction of its kind, the company sold securities worth $1.4 billion with the stipulation that investors' principal would not be returned in the "unlikely" event of an Enron default. Well, well, well, sort of brings back memories of Goldman Sachs as lead underwriter for Russian eurobond issues in June of 1998. Goldman enjoyed excellent timing, as $1 billion of issuance proceeds were used to repay a Russian loan, significantly cutting its exposure only weeks prior to the eruption of the Russian crisis. Leaving aside potential claims of insider information or related lawsuits in Citigroup's transaction, it is not rocket science to appreciate that speculators in such products will not be so easily "bagged" in the future. This is also further indication that huge losses have been suffered out there somewhere in "structured products."

Evidence certainly mounts by the week that this sordid Enron fiasco has significantly and permanently altered the face of structured finance and, importantly, the market for risk generally. Not only has the market for Credit default protection been irreparably damaged, it is today not too surprising that banks would prefer to avoid like the plague committing to backup lines of Credit to corporate America or Wall Street. Trust has been broken and the cadre of financial "engineers" is breaking rank - the structured finance cartel is in increasing disarray.

Which brings us to the government-sponsored enterprises. This week's revelation that the Whitehouse is understandably concerned with aggressive GSE growth is an interesting and potentially significant development. At the minimum, it throws an additional element of uncertainty onto an already nervous marketplace. I sympathize with the administration for having to deal with this unwieldy monster on their watch. But beyond political considerations, there are few institutions more directly in the cross hairs of unfolding developments than Fannie Mae, Freddie Mac and the Federal Home Loan Bank System. They are hopelessly obese risk and risk "mitigation" gluttons whose worlds are being transformed right before their eyes, whether they recognize it or not. Depending on how things play out, they could be at the precipice of liquidity problems, interest rate hedging issues, or Credit losses, or a combination, all risks they supposedly believe they have mitigated in the marketplace. A recent issue of Jim Grant's always interesting Grant's Interest Rate Observer profiled Fannie Mae, and included some candid and telling comments from the senior vice president of market risk oversight at Freddie Mac. He addressed the company's heightened concern with derivative market liquidity. Yes, the GSEs should be quite concerned, as market dynamics are changing rapidly with great uncertainty. Indeed, we are tempted to announce the arrival of critical problems in GSE risk management that have been in the making for years. At the minimum, they have become the market and are thus too big to meaningfully hedge.

Returning again to our favorite flood insurance analogy, protection is cheap and could not be more readily available in the carefree days after years of drought. A seemingly endless supply of insurance is assured from the large influx of enterprising "insurers" and speculators. But when the torrential rains eventually arrive and the crowds of proud new homeowners nestled along the riverfront look nervously out their windows at a rapidly rising river, panic is assured in the insurance marketplace as players scramble to "hedge." But the risk market will dislocate, with liquidity abruptly evaporating throughout the reinsurance marketplace as the specter of the unfolding catastrophe comes into focus.

The critical flaw in the derivatives market has always been that there would remain a viable and liquid market for "risk" and sufficient wherewithal within the financial sector to provide true insurance protection in the event of a systemic crisis. As we have argued repeatedly, the proliferation of derivatives has not mitigated but substantially increased systemic risk in one of financial history's unfortunate ironies. This dilemma, I would imagine, has of late become increasingly apparent to some key market players. Almost certainly, the halcyon era of the GSEs picking up the phone, hitting the speed dial to their favorite derivative salesmen at JPMorgan or Goldman Sachs to implement their hedging strategies is winding down. Going forward, the likes of JPMorgan and the Wall Street derivative players will be in a desperate struggle to manage their own risk with little appetite to "intermediate" risk for anyone else. The Fun is Gone From the Game of Risk.

With the risk market in disarray and key derivative players increasingly impaired, we will now be facing an environment of problematic risk contagion. I think the gold market is speaking loudly in this regard. Not only is the U.S. financial sector (and dollar) now locked in acute fragility, we have likely entered a period of extreme tumult as players in various risk markets - and let's not forget the speculators - begin to unwind positions. It is the very nature and vulnerability of highly leveraged institutions, and specifically aggressive speculators, that losses force their hands. We expect lots of hands to be forced. Instability in one market will beget instability elsewhere, as selling begets illiquidity and illiquidity begets selling and only greater efforts to mitigate risk. In the past, a purchase of derivative protection might sit on the books of the writer willing to speculate against the possibility of ever having to pay on a claim (i.e. writing puts against a decline in the dollar), with no impact on marketplace liquidity. Today, risk mitigation means selling securities, impacting market liquidity directly. We are always very conscious of the Fed and GSE's options in the face of heightened systemic risk, which they have used aggressively and repeatedly. But today we simply don't see how crisis can be averted for much longer. Another trillion dollars of money supply, $700 billion plus of mortgage Credit, and another year of record asset-backed security issuance perhaps. What will that get us but another year older and deeper in debt.

Getting back to Dr. Friedman and conventional doctrine, there has never been the appreciation for the severe consequences imparted by a massive accumulation of financial claims and the resulting Bubble economy structural distortions. Reading his analysis, it has always struck me that he believed if mechanisms were implemented (such a deposit insurance and the GSEs) that ensured continuous "managed" money creation while protecting against bank runs, the age-old business cycle would be largely conquered. This is a critical analytical error. It is also no coincidence that confidence in the power and omnipotence of the Federal Reserve were at their pinnacles during the late Twenties and late Nineties. It was precisely this blind faith, in confluence with spectacular technological innovation and seductive financial experimentation, that nurtured similar historic bouts of Credit and speculative excess. Not only are we approaching a critical juncture for the acutely vulnerable U.S. financial sector, the marketplace is about to come face to face with the shocking realization that the Fed has erred terribly and has little power to mitigate the deep structural damage imparted on the U.S. financial system and economy. Unfortunately, more money is not the solution, but will prove increasingly part of the problem. We do worry that there is today $8 trillion of what is perceived to be safe "money," backed by various promises, guarantees, Credit insurance, "default swaps" and other derivatives, as well as sophisticated structures and vehicles domiciled who knows where. It's a most dangerous confidence game. And in a troubling parallel to Argentina it is our view that the serious stage of the unfolding U.S. financial crisis commences with a faltering dollar.

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