There was certainly no let up in stock market volatility this week, as global financial markets continue in their especially unsettled states. For the week, the Dow and S&P500 gained about 1%. The Morgan Stanley Cyclical and Morgan Stanley Consumer indices were both virtually unchanged. The Transports dropped 3%, while the Utilities added 2%. The broader market continues to outperform the large caps, with the S&P400 Mid-Cap index adding 1% and the small cap Russell 2000 gaining marginally. Year-to-date, the small-caps have gained 6% and the mid-caps 8%. The NASDAQ100 gained almost 3% this week, with the Morgan Stanley High Tech and Semiconductor indices jumping 4%. The Street.com Internet index added 2%, while the NASDAQ Telecommunications index gained 5%. The biotechs had a strong week, rising almost 3%. The financial stocks performed well also, with the AMEX Securities Broker/Dealer gaining 3% and Bank index adding 2%. With bullion about unchanged, the HUI gold index nonetheless added about 3%.

The Credit market was mixed, with the front of the curve (short-maturities) outperforming. For the week, yields on December eurodollars dropped another 13 basis points, making it a decline of 63 basis points over the past 14 sessions. Two-year Treasury yields declined 4 basis points to 3.31%, while 5-year yields dropped 2 basis points to 4.52%. Ten-year yields, however, rose 4 basis points to 5.20, while the long-bond saw its yield rise 4 basis points to 5.69%. Benchmark mortgage-back and agency bonds outperformed, with yields generally declining one basis point. Fannie Mae saw the spread to Treasuries on its 5 3/8 2011 note narrowed 4 to 64. The benchmark 10-year dollar swap spread also narrowed 4 to 62. The dollar index dropped better than 1% this week, with the euro and pound moving to three-month highs against the dollar. Asian currencies gained as well, with the Taiwan dollar moving to four-month highs against the greenback.

Last week saw $34.9 billion of new U.S. public corporate and agency bonds issued, with Bloomberg's y-t-d tally at $526 billion, up 4.5% y-o-y. Convert.com has 54 new convertible bond issues y-t-d, with proceeds of $30.4 billion running up 30% from last year's record pace. Year-to-date asset-backed security issuance of $99 billion is running about 9% above last year's record. Almost $10 billion of asset-backs were issued this week, with home equity issuance about one-third of total volume. Broad money supply declined about $16 billion last week, with most of this explained by a significant drop in demand deposits. Perhaps this was tax related.

We keep a vigilant eye on quarterly earnings reports, especially following periods of aggressive Fed and GSE operations. These "reliquefication" periods - the response to the collapse of previous speculative Bubbles - generally usher in a new cycle of only more extreme Credit and speculative excess. As analysts, it becomes our focus to recognize the nature of the game and how it is changing - the sectors going out of favor and those that appear primed to receive at least their share of unfolding excess. To help in this analytical process, it is hopefully worthwhile to briefly take a look back at excerpts from a couple of earnings reports - post SE Asia/Russia/LTCM "reliquefication." Remember how the game quickly changed from the emerging markets to trading, underwriting and the technology Bubble. One could certainly have looked to earnings reports and garnered hints of what was to come.

Bloomberg reports on JP Morgan's Q1 1999 earnings: "The 137-year-old bank said profits from operations climbed to $600 million, or $3.01 a share, from $366 million, or $1.80, in the first quarter of 1998. Surging revenue from underwriting and trading stocks and bonds were responsible for most of the gains... J.P. Morgan's profit 'validates their strategy...' 'J.P. Morgan was in a business which was dead, which was large corporate banking. They've converted themselves, albeit with some problems, into a capital markets investment-banking firm...' At J.P. Morgan, credit-market revenue, which includes bond trading and underwriting, surged 91 percent to $696 million. Equities revenue from businesses such as underwriting stocks and trading equity derivatives, more than doubled to $288 million."

Bloomberg on Chase's Q1 1999 earnings: "Chase Manhattan Corp., the nation's second-largest bank, said first-quarter earnings rose a greater-than-expected 11 percent as securities trading and consumer banking gains more than offset lower revenue from junk-bond underwriting... Trading revenue and related net interest revenue was a record $837 million, up 21 percent from the same period last year. Securities gains rose 88 percent to $156 million, and gains from private-equity investments increased 11 percent to $325 million... The bank's noninterest revenue rose 20 percent to $2.94 billion, as credit-card revenue gained 26 percent to $379 million, trading revenue surged 29 percent to $618 million, and investment management fees increased 19 percent to $414 million."

Five months later, Chase purchased Hambecht and Quist for $1.35 billion and dove headfirst into technology IPOs, telecom debt underwriting, equity derivatives, and aggressive private equity investments. Bank of Boston (later acquired by Fleet) had purchased Robertson Stephens the previous year in a mad rush by the major banks to play the IPO boom and technology Bubble. Tech was the "hot game" and everybody wanted a piece of the action. Now, post-tech Bubble, we see that FleetBoston is admitting that expected "synergies" never developed and is looking to dump Robertson Stephens. Almost across the board, we note that banks are now looking to pare back "principal investing," equity underwriting, and commercial lending. Nowadays, every banker seems to recognize that consumer and mortgage finance is the "safe" growth business going forward. We find this very troubling, and as further evidence supporting our view that the financial sector is in gear to finance the terminal stage of consumer Credit excess. Please read carefully the following comments and analysis from some of our country's largest lenders.

From Washington Mutual, the nation's largest Savings and Loan: "Record loan volume of $65.27 billion, including a 187 percent increase in total single-family residential loan volume and a 39% increase in [non-single family residential] loan volume from the first quarter of 2001." While acquisitions make comparisons difficult, it is worth noting that origination volumes increased 10% from very strong forth quarter lending. From National City Bank, the nation's ninth largest, after reporting a 19% increase in revenues and record earnings: "The blockbuster performance of our mortgage banking business this business cycle provided us with the capacity to produce record-breaking financial results while we prudently addressed credit issues... Commercial loan activity continued to be sluggish, but consumer and mortgage loan volumes were relatively strong." Year-over-year, average asset balances were up 17%, with average loans up 3%. Commercial loans were down 3%, credit cards declined 16%, and other consumer loans were down 7%. At the same time, residential real estate loans were up 10%, commercial real estate 17%, and home equity loans were up 25%.

From Bank of America's Financial Highlights: "Mortgage banking income grew 59 percent led by continued strength in origination volume and margins." Year-over-year, total company revenues increased 2%. "Global Corporate and Investment Banking" revenue declined 5%, with earnings down 13% y-o-y. "Asset Management" revenues were "slightly below" last year, with a small gain in earnings. "Equity Investments" reported a loss of $32 million compared to last year's earnings of $33 million. Meanwhile, "Consumer and Commercial Banking" revenues were up 10% and earnings increased 11%. "Average loans grew 4 percent, led by consumer loan growth of 20 percent, primarily in residential first mortgage and credit card." Consumer credit card outstandings held were up 33% y-o-y to $19.5 billion, while total loans and leases in the Global Corporate and Investment Banking segment were down 29% to $65 billion. Total managed Consumer Credit Card outstandings were up 15%, while total Global Corporate and Investment Banking earning assets were down 2% y-o-y.

Bloomberg quoted Wells Fargo CEO Richard Kovacevich (through a spokesman): "The mortgage industry will be solid through the first half of the year because interest rates and unemployment are low by historical standards and consumer confidence as a result remains high." From the company's earnings release: "Commercial loans outstanding modestly declined in the first quarter in line with slow economic growth. However, we are extremely pleased with the continued strong consumer loan growth largely driven by strong sales of our industry-leading home equity and home mortgage products." Average core deposits are up 13% y-o-y to $178 billion. First quarter mortgage originations of $68 billion were up 134% y-o-y, with Wells' mortgage servicing portfolio surpassing one-half trillion dollars. The company's home equity loans were up about $2 billion for the quarter (32% annual growth rate), with home equity loans up 46 percent y-o-y.

Year-over-year, Wells' total assets were up 11.4%. One does not need to dig to deep to into the composition of the company's loan portfolio to get a good idea of the way commercial banking is moving. Consumer loans expanded at a 17% rate during the quarter and are up 18% y-o-y. Year-over-year, commercial loans declined 4% to $47.4 billion, while total mortgage related loans jumped 28% to about $90 billion. By the two largest categories, "real estate 1-4 family first mortgage" were up 50% to $28.5 billion and "consumer - real estate 1-4 family junior lien mortgage" (home equity loans) were up 47% to $27.7 billion." Curiously, the only mortgage category not showing strong growth was "construction" that actually declined slightly y-o-y. Elsewhere, other consumer loans were basically unchanged from one year ago.

Looking at Citigroup y-o-y revenues by segment, we see "Global Corporate and Investment Banking" down 11%, "Emerging Markets Corporate Banking and Global Transaction Services" down 11%, "Total Global Investment Management and Private Banking" down 12%, and "Total Travelers Property and Casualty" up 5%. Meanwhile, Citigroups's "Total Global Consumer" segment saw revenues surge 20%, led by "Citibanking North America" up 25%, "Mortgage Banking" up 25%, and "North America Cards" up 14%. Total North America consumer revenues were up 14% y-o-y.

At JPMorgan Chase, investment banking revenues were down 16% y-o-y, investment management revenues were down 10%, and "Treasury securities and services" were down 2%. Meanwhile, "Retail and Middle Market" were up 18%. Looking at operating earnings, investment banking earnings were down 27% y-o-y, while retail and middle-market were up 25%. Commercial loans were down 3% for the quarter and 10% y-o-y. Elsewhere, credit card loans outstanding jumped 31% y-o-y to $49 billion.

Household International (HI) earnings were up 18% year-over-year. Total company assets were up 16% y-o-y to $90.4 billion. Total managed loans increased 15% to $101.2 billion. Managed real estate loans increased at a 14% rate during the quarter, and were up 22% y-o-y to $46.3 billion. Managed real estate loans are up 72% over the past nine quarters. Household is one of those companies that came under close scrutiny during the quarter, and it is worth noting that it used proceeds from securitizations to reduce its commercial paper borrowings by one-third to $5.8 billion.

The Capital One Bubble continues to expand. For the quarter, total assets expanded at a 44% annual rate to $31.3 billion. Total assets are up 50% y-o-y. Total managed loans increased at a 29% rate during the quarter, and are up 54% y-o-y. The company added 2.8 million new accounts during the quarter to 46.6 million. Industry leader MBNA added 2.4 million new customers during the quarter, with total managed loans up 8.5% y-o-y to $95.4 billion. Company assets are up 18% y-o-y to $46.5 billion.

Fannie Mae enjoyed record business volume (total mortgage purchases) of $197 billion for the quarter, with y-o-y revenues up 26%. During the past 12 months, Fannie's total book of business (mortgages retained and guaranteed mortgage-backs sold into the marketplace) increased a stunning $262 billion, or 19%, to $1.63 trillion. If nothing else, at least the chatter that they are but 10% of the mortgage industry has died down. To put this growth into perspective, Fannie's total book of business increased $145 billion during the preceding 12-month period (Q2 2000 through Q1 2001). It is also worth noting that Fannie's 12-month book of business growth surpasses total annual U.S. household mortgage debt growth for any year prior to 1998 (commencement of mortgage finance Bubble), with total U.S. household mortgage growth averaging $194 billion during the first 8 years of the nineties.

Interestingly, despite Fannie's average retained mortgage portfolio expanding at a 15% rate during the quarter, the company's total assets increased at only a 4% rate. This anomaly is explained by the company reducing its short-term "liquid investments" by $18.8 billion during the quarter to $57.3 billion. At year-end, Fannie Mae "liquid investments" included $21 billion of asset-backed securities, $12 billion of commercial paper, $12 billion of floating rate notes, $11 billion of eurodollar deposits, $9.4 billion of repurchase agreements, $5 billion of fed funds, and $4 billion other investments. Fannie Mae's decision to finance its mortgage purchases by running down "liquid investments" provides a good illustration of an operation that has pressured money supply expansion during the first quarter. Now that 2001 financial statements are available, we see that Fannie increased short-term borrowings last year by $63 billion, or 23%, to $344 billion.

This week from the LA Times' Daryl Strickland: "The housing market across much of Southern California grew at a blistering pace last month, achieving the strongest sales and price gains in any March in 13 years. Los Angeles County's median home price jumped 15% from a year ago to a record $251,000, according to a report released Tuesday by DataQuick information Systems Inc. Sales of new and existing homes rose 17% to 10,651, the highest level in March since 1989. Sales and prices also grew robustly in Orange County and other markets as buyers across much of the region searched anxiously for the right house. Brokers said multiple offers grew more common in March, pushing up the cost of homes and leaving first-time buyers, in particular, frustrated at their lack of options... In Southern California, barring a severe change in consumer sentiment, current conditions could be sustained through much of the year... John Karevoll, the analyst who compiled the report, sees faster growth through summer and into fall throughout California. 'The trends are quite uniform across the board.'" For the first three months of the year, both sales and price gains are the strongest since the late 1980s.

This week from the San Diego Union-Tribune's Roger Showley: "San Diego County housing prices rose last month nearly 17 percent from the same month in 2001, crossing over the $300,000 threshold for the first time... The overall median for new and existing houses and condominiums was $304,000, up from $260,000 in March 2001, and $15,000 more than in February 2002. Existing single-family homes, which had hit the $300,000 mark in February, rose to $307,250 and existing condos were up 22.2 percent, from $180,000 in March last year to $220,000 last month. Newly built houses and condos rose 14 percent to $394,000, no doubt headed for the $400,000 mark this month."

From another Daryl Strickland LA Times article: "Flush with a $95,000 profit from a Los Angeles County home, Mike Riach thought he'd have no trouble finding a house he could afford in Ventura County. But the 33-year-old firefighter lost out on a full-price offer in Ventura. Then he found that just about anything in his price range was sold by the time he saw it. Finally, after months of hunting, Riach and his wife, Suzie, got lucky in a lottery-type sale in Camarillo and bought the last model home in a new subdivision for $340,000. Eighty people had signed a waiting list for the opportunity. 'They called out our name and my wife jumped up screaming,' he said. The victory will cost the Riaches 44% of their take-home income each month. 'It's $100,000 more than I wanted to spend; just way too much,' Riach said. 'But it's really good for today's market. It's amazing what's going on.' In the last two months, Ventura County's scorching housing market has gotten so hot that some veteran agents say it matches or surpasses the real estate run-ups of the late 1980s. Bidding wars are back, agents say. Some owners sell their own homes without an agent in days. And even houses priced above the perceived market are fetching more than owners are asking. 'It's almost as if somebody flipped a switch in late January, and everybody came out in droves,' said Ventura agent Harold Powell. 'In the last month we've had multiple offers on four or five properties. Three of them have sold over the asking price.' Those houses sold for $285,000 to $500,000, he said. A year or two ago, they would have cost $50,000 to $100,000 less."

All of the sudden the media is taking an interest in the real estate Bubble. Kudos to Barron's talented Jonathan Laing for his excellent piece last week, "Home Grown - Rising Prices have kept the economy afloat. What happens if the bubble bursts?" It seems to have struck a nerve...

Excerpt from a Bloomberg interview as Fannie's Franklin Raines responds to an inquiry about the possibility of a housing Bubble: "Well, we see this bubble argument every 10 years. It was made at the beginning of the '90s and now we're seeing it again right now. And the fundamental flaw in it is that people are comparing housing, where people actually live with speculative investments in the stock market or commodities or other things that can be turned into bubbles. People live in their homes, and they borrow in order to own the home. If we were experiencing a bubble, we'd be seeing supply flooding into the market, and we're not seeing that. What's actually happened is there's a shortage of supply in the market and that's what's driving up the cost of homes. But home prices, overall, given these interest rates, remain surprisingly affordable. So the average consumer is not experiencing this kind of pressure. You will see it in local markets. You will see some local markets that may take on bubble characteristics from time to time. But we haven't seen a national decline in housing prices in 30 years. So I think that the bubble rhetoric, although it makes for a nice article, is not really grounded in the fundamentals of the housing market."

From Alan Greenspan's prepared testimony before the Joint Economic Committee, April 17, 2002: "The ongoing strength in the housing market has raised concerns about the possible emergence of a bubble in home prices. However, the analogy often made to the building and bursting of a stock price bubble is imperfect. First, unlike in the stock market, sales in the real estate market incur substantial transactions costs and, when most homes are sold, the seller must physically move out. Doing so often entails significant financial and emotional costs and is an obvious impediment to stimulating a bubble through speculative trading in homes. Thus, while stock market turnover is more than 100 percent annually, the turnover of home ownership is less than 10 percent annually--scarcely tinder for speculative conflagration. Second, arbitrage opportunities are much more limited in housing markets than in securities markets. A home in Portland, Oregon is not a close substitute for a home in Portland, Maine, and the 'national' housing market is better understood as a collection of small, local housing markets. Even if a bubble were to develop in a local market, it would not necessarily have implications for the nation as a whole."

Then there was Federal Reserve Bank of New York President William McDonough's response yesterday in Long Island to a question regarding the possibility of a real estate Bubble: "The prices of Manhattan real estate are once again defying the law of gravity and going up. Since I own an apartment in Manhattan, I think that's a very good thing. I think we have to be very careful to distinguish - actually Greenspan did a very good job of this before the Joint Economic Committee yesterday - to distinguish between a stock market Bubble, which is a macro economic issue, and real estate (inaudible) people's homes and apartments and commercial. In all cases, even commercial, they are local markets. So if you had - let's stay away from Long Island - if you had in Manhattan a market which was overpriced and people stopped bidding for apartments and the price had to go down, that's a problem for Manhattanites. It wouldn't affect you in the slightest. It certainly wouldn't affect anybody in Chicago, Denver, San Francisco. So the likelihood of having a home real estate Bubble nationally is very low - because it's a collection of individual markets. Some of the markets are quite frothy, because people want to live there. And, as for example, in Manhattan in the golden days of yuppie traders very young people were buying houses that the rest of us wouldn't have dreamed of until we were a lot older than they. But that's come and gone and the prices have stayed pretty well. So I don't think we have to be concerned about it - a residential real estate problem, even though the value of people's homes nationally has continued to go up. That has made people feel richer. Most rich Americans own both homes and stocks. Most Americans own not very much stock - it's in a 401K plan and they think about it as something for their retirement and they don't really change their spending habits very much in relation to it. The important thing is the value of your home. The value of your homes has continued to go up; that has made people richer. They look at their balance sheet and they say 'I can spend more.' So it is adding positive effects on consumer spending without any doubt. But I don't think it is in a position now where we expect it to become a macro economic problem."

It is fascinating - and a not insignificant development - that we have arguably the three most powerful men in U.S. finance - Greenspan, Raines, and McDonough - attempting to throw cold water on the increasing talk of a U.S. real estate Bubble. From reading these individual comments, one would almost forget that the a real estate Bubble virtually destroyed the Japanese financial system; that U.S. financial history is replete with housing boom and bust cycles; and that the U.S. banking system was severely impaired from the consequences of the late-eighties real estate lending boom. It is even more curious that all three have chosen to use the "local markets" argument against the Bubble view, an especially unconvincing argument today.

We all are familiar with the dilemma of fudging the truth. In response yesterday to a question from Representative Dunn regarding unemployment, Alan Greenspan responded with the following: "And the one thing one can say about the American economy is that it is really far more a single economy than it has been at any time in my recollection. All aspects of this economy -- actually, I'll put it this way. There are not the significant geographic differences that we used to experience three, four and five decades ago. Very recently we are finding that when we survey all of various different industries and various regions of the country, it is remarkable throughout, say, 2001 they behaved very much in sync with one another. It would almost replicate the discussions in one area and another -- with another, and that's still true to this day. And with the recovery coming back we're seeing very much the same phenomenon; everyone's moving together."

So much for "local markets." There is absolutely no doubt that the U.S. economy is "really far more a single economy" than ever before. The key explanation is rather obvious, and it lies with the national character of the Credit system. No longer do local bank loan officers dictate the pace of local commerce and investment. National securities markets have supplanted local bankers as the major players in Credit creation. The commercial paper market, mortgage-back securities, asset-backs and other securitizations, syndicated bank lending, and the gargantuan bond market absolutely dominate contemporary finance. And with the rise of securities markets and endemic Credit market speculation, Credit availability is overwhelmingly dictated by whatever the hot game is on Wall Street. Today, the hot game and domination reside in mortgage finance no matter how much Greenspan or anyone else wants to downplay its significance.

I would like to try to be clear on one point: The issue in not so much a traditional "housing Bubble" per se, but a precarious Bubble throughout mortgage finance. The nature of the problem is first and foremost financial excess, and secondarily a real economy development. And, in fact, this simply could not be further from a "local market" issue. We warned about the GSE and mortgage finance Bubble back at our Credit Bubble Symposium in September of 1999. Amazingly, since then Fannie Mae's total book of mortgages has surged about $450 billion, or nearly 40%. National housing prices have followed closely behind. Mr. Raines and others have stated (unconvincingly) that Bubble analysis is inapt, as we haven't experienced overbuilding and excessive housing inventory. But that is exactly the point. Builders' memories from a decade ago remain clear, and their bankers appear to be keeping a relatively tight leash. The problem lies elsewhere, where the GSEs and over liquefied securities markets have unleashed wild lending and speculative excess. The consequence has been unprecedented availability of inexpensive mortgage finance, with this liquidity reverberating throughout the financial system. We would even go so far to say that the situation would have been significantly less dangerous to systemic stability had the Bubble been in homebuilding. This would have tended to keep prices from inflating to such an extent, inflation that has led to a self-reinforcing Bubble of over borrowing, asset inflation, over spending, the accumulation of unprecedented foreign debt, and severe structural maladjustments to the real economy. If only the issue was housing inventory...

Back during the height of the Internet Bubble, Greenspan made comments to the effect that the speculation in the stock market was akin to people buying lottery tickets. His (and the media's) focus was misdirected. Not appreciated at the time was that the most damaging Bubble was not to be found with individuals speculating in the Internet stocks, but rather with wild lending and speculative excess running out of control throughout telecom junk bonds, securitizations, CDOs, syndicated bank lending, special purpose vehicles, and other areas of "structured finance". The critical issue was the "hot game" on the institutional side (as opposed to the daytrader), and the consequences of a highly speculative Credit market providing the key liquidity to the industry Bubble. The retail stock speculator was but a consequence, and certainly not a cause, of the overriding Bubble running out of control in the Credit system. Over time, the massive over liquidity from too many institutions playing too aggressively led to self-destruction. And when the telecom debt Bubble inevitably began to burst, it quickly became clear how distorted the whole process had become. A virtual stampede quickly developed as players tried desperately to get out before the imminent collapse.

Today, similar speculative dynamics again emanate from the Credit system. But the mortgage finance Bubble is on a much grander scale, and is covertly imparting severe structural distortions on a much more systemic basis. This round of Credit Bubble inflationary manifestations is imparting more generalized asset inflation, particularly in the housing market, and consequent increasingly serious distortions to the structure of demand and investment. It is our view that the severity of the U.S. economy's maladjustment will (like the tech Bubble) also quickly become evident when the over-liquefied situation in the securities markets subsides. This vulnerability makes the current environment all the more precarious. Moreover, we are very concerned (as we have tried to explain repeatedly) that the mortgage finance Bubble has come to play the critical role in keeping the contemporary U.S. (global?) securities markets liquid, while at the same time providing the vital mechanism for recycling surplus dollars. Liquidity can be a very fleeting thing, and today the dollar looks quite vulnerable. Again, this is anything but a "local" housing market issue; it is anything but just a housing issue. Mr. McDonough may believe that if New Yorkers "stopped bidding" for apartments and prices "had to go down" that it's a problem only for "Manhattanites." We are much less sanguine, as our fear lies elsewhere: the inevitable bursting of another speculative Bubble of much greater dimensions. The consequences will be very national when bidding wanes for mortgage-backs, agency bonds, and home equity securitizations. And if Dr. Greenspan is today comforted that he sees little evidence of the "turnover," "speculative conflagration," or "arbitrage opportunities" typically associated with a speculative Bubble, we suggest he take a look in the murky world of leveraged speculation in mortgage-backs, agency debt, and the repo market.

Back in August of 1999 at the annual Jackson Hole central banker shindig, Dr. Greenspan presented a fascinating speech titled New challenges for monetary policy. Buried in his talk was analysis that hits on a great fallacy of contemporary central banking that is especially pertinent today:

Greenspan, August 27, 1999: "History tells us that sharp reversals in confidence happen abruptly, most often with little advance notice. These reversals can be self-reinforcing processes that can compress sizable adjustments into a very short time period. Panic market reactions are characterized by dramatic shifts in behavior to minimize short-term losses. Claims on far-distant future values are discounted to insignificance. What is so intriguing is that this type of behavior has characterized human interaction with little appreciable difference over the generations. Whether Dutch tulip bulbs or Russian equities, the market price patterns remain much the same. We can readily describe this process, but, to date, economists have been unable to anticipate sharp reversals in confidence. Collapsing confidence is generally described as a bursting bubble, an event incontrovertibly evident only in retrospect. To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific companies that make up our broad stock price indexes. If episodic recurrences of ruptured confidence are integral to the way our economy and our financial markets work now and in the future, it has significant implications for risk management and, by implication, macroeconomic modeling and monetary policy."

Over time, it is rather obvious that the Greenspan Fed has come to believe that it has the responsibility to protect against the results of temporary bouts of "collapsing confidence." This role takes on monumental significance in the contemporary, securities market-dominated financial system. The problem is to recognize that the system is always adapting and evolving - entrepreneurs, financial players and institutions adjust away from problems and move forward to exploit opportunities. Monetary policy can have varying and unpredictable consequences. Nowhere is this more true than with financial players seeking to profit from the Fed.

It has been an enormous mistake for the Fed to associate bursting Bubbles with collapsing confidence. The analytical focus should not rest with market confidence, but with speculative impulses and evolving debt structures. Bubbles collapse specifically because they are unsustainable; confidence necessarily follows the collapsing Bubble. We saw precisely these dynamics unfold with the telecommunications Bubble, where speculative forces created unsustainable monetary flows, gross industry distortions, and unstable debt structures. A bust was unavoidable because the flood of liquidity being thrown on this sector ensured that sustainable profits and positive business cash flows would be impossible for the majority of enterprises. Any reversal of speculative flows would quickly illuminate acutely fragile financial structures, with a mad scramble to the exits absolutely unavoidable. But this is the very nature of speculative Bubbles - they are inevitably issues of illiquidity. If everyone is in the game, there is a problem as soon as the game doesn't look so good or another looks a little better. Everyone is not in the game forever.

A quote from Edward S. Shaw, Monetary Policy and the Structure of Debt, The American Economic Review, May 1954, pp. 476-477 "...All of us realize that monetary policy reverberates through the debt structure as a whole. Its impact on real variables is conditioned by the way in which the debt structure responds. This implies that the speed, force, and locus of impact are not the same in all economic systems or in one economic system at all times...the financial structure which emerges from a specific growth process has its own distinctive way of reacting to and transmitting the impact of monetary controls..."

Today, extreme Fed accommodation is being transmitted most directly to mortgage and consumer Credit excess. We believe the ramifications are enormous. First of all, we view mortgage finance as the last remaining sector with the dimensions necessary to sustain the systemic Credit Bubble. As goes mortgage finance, so goes the Credit Bubble, the strong dollar, and the vaunted "resiliency" of the U.S. Bubble economy. Second, this is a particularly dangerous stage of the Credit cycle, as the preponderance of lending and speculating is reverberating through non-productive debt creation. We simply cannot imagine the creation of a more fragile debt structure, and this is why we state unequivocally that this has been following the worst-case scenario. In fact, in reviewing recent bank earnings releases we see an especially troubling trend: not only are lenders moving toward a new level of consumer lending excess, but it is almost as if the entire financial sector is looking to reduce exposure to commercial lending. If this combination proves the key dynamic of this period, this would be a very different animal than we have seen before. We should be prepared to expect atypical inflationary consequences over time as long as these dysfunctional monetary processes are maintained.

I am reminded of analysis I read from the Federal Reserve from the early 1990s. The point was being made that the Fed's aggressive accommodation was in reality advantageous in the context of long-term inflationary performance; policy was attenuating pressures for companies to close plants and reduce capacity. When the economy recovered, this capacity would be instrumental in satisfying heightened demand with minimal inflationary pressures. I thought this interesting analysis at the time, but perhaps this line of reasoning has more relevance today after a decade of plant closings and "de-industrialization." I continue to think a reasonable case can be made that the financial sector is now proceeding on a course raising the possibility that a surprise could come with heightened general inflation - from over stimulating consumption while avoiding the finance of new capital investment. We saw this week a worse than expected $31.5 billion February trade deficit, with a strong bounce back in imports. There is, furthermore, no longer the technology sector acting as the magnet absorbing excess system liquidity, as has been the case for several years. So we are left to ponder the very interesting circumstance that has the financial sector pressed to create the enormous Credit necessary to keep the Credit Bubble and Bubble economy levitated, but no clear avenue for consequent inflationary manifestations outside of housing and trade deficits.

Watching chairman Greenspan this week, I couldn't help but to sense that things are finally beginning to close in on him. I don't think his unconvincing housing Bubble commentary and incessant reference to "productivity" as some kind of magic elixir is going to suffice. Perhaps the markets are coming to appreciate that endemic financial sector leveraging and speculation has the Fed trapped in dangerously accommodative policy, leaving Greenspan little alternative but to look the other way from the conspicuous housing Bubble, intractable trade deficits, severe economic maladjustments, and heightened inflationary pressures. This is not the circumstance of a strong currency, and it was not a good week for the dollar. The question then becomes, is the weakening dollar a harbinger of waning demand for U.S. Credit market instruments? If so, such a development would mark a major inflection point for the leveraged speculators and, hence, the Great Credit Bubble. Up to this point, the Fed has been able to resolve every bursting Bubble with sufficient accommodation to fuel the next larger one that keeps the game going. But it hasn't been a case of sustaining faltering confidence as much as it was inciting continued Credit excess. Hopefully the members of the Fed haven't convinced themselves that the markets will always be so accommodating. When the current Bubble in mortgage finance wanes, the Fed is going to be faced with a dilemma much more problematic and unlike any it has faced previously.