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Untenable Monetary Regimes

Total Freddie Mac Assets
Fannie and Freddie Assets
Fannie and Freddie Combined Book of Business
Mortgage Purchase Application Index

U.S. financial markets took a decidedly ominous turn this week, with a collapsing technology sector and faltering dollar raising potential concerns as to the soundness of the U.S. financial system. For the week, the Dow declined 3% and the S&P500 dropped 4%. The Transports, Morgan Stanley Cyclical, and Morgan Stanley Consumer indices all dropped 3%. The Utilities declined only 1%. The broader market suffered its worst period of weakness since February, with the small cap Russell 2000 and S&P400 Mid-Cap indices dropping 3%. Across the board, the technology sector was hammered. For the week, the NASDAQ100 was hit for 10%, the Semiconductors 12%, and the Morgan Stanley High Tech index 8%. The Street.com Internet index sank 12%, and the NASDAQ Telecommunications index was clobbered for 14%. The Biotechs came under heavy selling pressure as well, sinking 11%. With the brokerage community now under intense scrutiny, the AMEX Security Broker/Dealer index sank 9%. Bank stocks generally held their own dropping 3%. With bullion surging $9.10, the HUI Gold index jumped 9%.

The Credit market again enjoyed all the tumult. For the week, 2-year Treasury yields sank 17 basis points to 3.15%, 5-year yields dropped 15 basis points to 4.37%, and 10-year yields dropped 15 basis points to 5.05%. The long-bond saw its yields sink 10 basis points to 5.59%. December eurodollars saw their yields drop another 18 basis points to 3.11%. Benchmark mortgage-backs generally underperformed, as yields dropped 12 basis points, while agency yields dropped 17 basis points. The spread on Fannie Mae's 5 3/8 2011 note narrowed 1 to 63. The benchmark dollar swap spread narrowed 4 to 58. The dollar was weak against all major global currencies, with the dollar index dropping 1%. Asian currencies continue to rally, with the Singapore dollar rising to a 6-month high against the dollar and the Taiwan dollar to a 4-month high. The euro rose to the highest level against the dollar since early January.

Today's report of 5.8% first-quarter GDP growth confirms that there has been quite a resumption of borrowing and spending. We also see that retail spending remains relatively robust and the housing market buoyant. It certainly appears, however, that the U.S. stock market and global currency markets are coming to appreciate that what we are experiencing is not an economic recovery as much as it is a last gasp of a terribly maladjusted Bubble economy. While finance floods into a problematic mortgage finance Bubble, the ongoing technology collapse takes a decided turn for the worse. It should be coming increasingly clear why the Fed made a momentous error in responding to the bursting of the technology Bubble by accommodating only further speculative and Credit excess. Such policies only created another larger Bubble and a precariously imbalanced U.S. economy.

April 25, Bloomberg - "American Express Co. is following General Electric Co. and Household International Inc. in reducing its dependence on short-term borrowing to ease concerns raised by investors and rating companies... The largest U.S. travel agency used proceeds from bond sales and cash on hand to lower outstanding commercial paper by almost a quarter in the first three months to $14 billion at the end of March." Broad money supply declined $10.8 billion last week, with institutional money market fund assets declining $5.4 billion and repurchase agreements dropping $7.9 billion. Bloomberg reported total U.S. debt issuance of $25.5 billion last week, with y-t-d issuance of $540.3 billion. About $5 billion of asset-backed securities were issued last week, bringing y-t-d issuance to $100 billion (up 10% y-o-y). To this point, it appears that the abrupt slowdown in money supply growth corresponds with heavy bond issuance and the financial sector reducing short-term borrowings. With heavy demand for long-term debt issues and collapsing Credit spreads, we don't see money stagnation it at this point as a liquidity issue. However, if demand for longer-term debt instruments begins to wane (we expect the weakening dollar to be a catalyst in this regard) and this is not met by a resumption of money expansion, liquidity could quickly become an issue. We will be following this closely going forward.

From the Fed's Beige Book: "Residential real estate activity remained robust. Housing markets were reported to be strong in most districts, with both home sales and new construction showing continued gains. The housing market in the Boston district was described as very strong, with listings in short supply throughout the region. In New York, further strengthening in home sales has caused the number of unsold homes to dwindle and has led to some acceleration in housing prices. Richmond also reported especially strong housing activity."

March certainly saw no air come out of the California real estate Bubble. For the month, average (median) prices jumped to $305,940, surpassing $300,000 for the first time. Prices were up 2.6% from February and 18.8% y-o-y. Sales were up 13.1% from year ago levels, while the inventory of available homes dropped to a noteworthy 2.3 months (compared to 3.5 months one year ago). The median condominium price of $249,820 is up 21.5% y-o-y, with the number of sales up a blistering 38.5%.

The Mortgage Bankers Association's weekly application index increased 6% last week, as declining mortgage rates stimulated both refinancing and purchase applications. Importantly, the purchase application component increased 4% last week to 351.6, one of the highest levels ever and compared to October lows of 264. Purchase applications are up 21% y-o-y. The Commerce Department reported Wednesday that new home sales declined 3% in March to a seasonally adjusted annualized rate of 878,000 units, but at the same time sharply revised February's sales from the initial report of 875,00 to 906,000. It is worth noting that the Midwest saw new home sales drop 19%. The average new home price was $222,900, with 29% of sales above $250,000. For comparison, the percentage of above $250,000 was 23% during 2000 and 25% during 2001. Yesterday the National Association of Realtors reported that March existing home sales dropped back from January and February's blistering pace. March's seasonally adjusted and annualized sales rate of 5.4 million is less than 1% below year ago levels, with first quarter sales firmly on record pace. March's average price of $192,400 is the highest since August and up $12,900 (7.2%) y-o-y.

From Countrywide Credit's earnings release: "Fueled in part by record purchase production volumes, total loan funding for the quarter surpassed $44 billion, an 85% increase over the first calendar quarter of 2001." Total purchase fundings of $18 billion were up 64% y-o-y. Countrywide's total assets increased $5.4 billion to $42.6 billion, an annualized growth rate of 58%. Year-over-year, total assets are up 62%. Countrywide began year 2000 with total assets of $15.6 billion. Over the past twelve months, "Investments in other financial instruments" has jumped from $3.4 billion to $9.1 billion. This asset category includes "home equity line of credit senior security" of about $2.6 billion, "principal-only securities" of $3.3 billion, and "total other interests retained in securitization" of $1.2 billion. Countrywide also has "other assets" of $7 billion, including "defaulted FHA-insured and VA-guaranteed loans repurchased" of $1.9 billion and "mortgage loans held for investment" of $1.6 billion. Perhaps these mortgage "investments" are related to problem mortgages that Fannie and Freddie send back to the originators. Funding this ballooning balance sheet is $17 billion of notes, $10.5 billion of "securities sold under agreements to repurchase" and $2.2 billion of "bank deposit liability." A few months back I wrote that I expected Countrywide's business to slow as mortgage rates rose and refinancing volumes declined sharply. I was wrong.

From Freddie Mac's "Highlights for first quarter 2002: Record new business purchase volume of $151 billion, up 86% from $81 billion for first quarter 2001. Retained portfolio growth of $34 billion, representing 28% annualized growth. Record PC ["Participation Certificates"/mortgage-backs] growth of $64 billion, representing 27% annualized growth." It is worth noting that while Freddie's total assets jumped $29 billion during the quarter, short-term borrowings increased only $713 million. This is another important example of a major financial institution's liability management activities helping to explain the abrupt stagnation of money market fund assets and money supply generally. The slowdown of money expansion is not the Fed's doing, but because of the changing composition of liabilities issued by the financial sector. To put Freddie's minimal first quarter short-term borrowing increase into perspective, during the preceding nine months (3/31/01-12/31/01) Freddie Mac increased short-term borrowings by $56.6 billion, while long-term debt increased $48.1 billion. During the past 12 months, Freddie's total assets have increased almost $149 billion, or 30%, to $646 billion, while shareholder's equity has increased $3 billion to almost $16 billion. Freddie's total assets are up 288% over the past five years. Freddie's total assets ended September 1993 at about $67 billion and surpassed $100 billion for the first time during the fourth quarter of 1994. They now add about $100 billion of assets in eight months. This is why we talk in terms of the parabolic "blow off" in mortgage finance.

Greenspan this week raised the issue of GSE subsidies and derivative risk, and made the strange comment, "Presumably, counterparties can manage this risk effectively through the use of credit limits, netting, and collateral agreements." Sometimes he seems oblivious to the fact that borrowing short and lending long creates interest rate and liquidity risk, and when it is done to the egregious extent of the GSEs, it creates systemic risk that is impossible to mitigated with "netting" or "collateral agreements". Greenspan also stated, "we need to be careful not to allow subsidies to unduly disturb an efficient financial structure..." Such comments ring so hollow, and it's not the least bit surprising at this stage that the market disregards Greenspan when it comes to the GSEs. The Fed is hostage to the GSEs and the market appreciates this clearly. And while Greenspan, The Wall Street Journal, and others focus on subsidies, disclosure, and other subordinate issues, we appreciate that Paul Volker accurately and succinctly gets right to the heart of the matter: "I think the issue with Fannie Mae and Freddie Mac is one of size."

Over the past 12 months, Freddie's total book of business (retained mortgage portfolio and mortgage-backs sold into the marketplace) increased $209 billion, or 20%. This compares to $118 billion growth during the preceding 12 months. Freddie and Fannie's combined book of business surged an incredible $471 billion (20%) during the past year to $2.83 trillion. This compares to the $262 billion expansion during the preceding 12 months. During the past 36 months their combined book of business has jumped $953 billion, or 51%. To put this number into perspective, total household mortgage growth increased $955 billion during the three years 1999 through 2001.

We have in past analyses combined Credit growth from the GSEs, mortgage-backs, and asset-backed securities and labeled this "structured finance" Credit. Last year, surpassing $1 trillion for the first time and up four-fold from 1993, new "structured finance" Credit creation went to a new level of excess. In fact, the $1.003 trillion was not only up from 2000's $647 billion, but it jumped to 91% of total U.S. non-financial borrowings. For comparison, the "structured finance" ratio of combined GSE, MBS, and ABS Credit growth as a percentage of total non-financial U.S. borrowings increased from 2000's 74.2% ($646.7B/$871.6B), 1995's 50.2% ($354.4B/$705.9B), and 1993's 43% ($248.9B/$579.4B). At this point, there should be no denying the reality that "structured finance" has evolved into the key monetary transmission mechanism to the real economy, as well as the key liquidity mechanism for the securities markets. Furthermore, with much of last year's new Credit intermediated through the money market funds and other "monetary" liabilities, this most unusual of Credit mechanisms was largely responsible for the uninterrupted flow of easy Credit to the mortgage and consumer sectors - the true source of the vaunted "resiliency" of the U.S. economy in the face of severe financial tumult.

It is, importantly, our contention that what we really are dealing with is an historic experiment with a New Age Monetary Regime. The consensus view is that with deregulation and extraordinary innovation, the U.S. financial system has developed into a modern miracle of "efficient" contemporary finance. For good reason, we don't believe in financial miracles. Instead, we see a Monetary Regime that has evolved into a system that fosters precarious excess. With this in mind, it is our view that there is much to be gleaned from the unfolding debacle in Argentina.

While we would certainly in places take a different analytical approach and come to divergent conclusions, for excellent background and valuable insight I highly recommend Michael Mussa's (Senior Fellow, Institute for International Economics, and formerly IMF staff member for the past decade) article, Argentina and the Fund: From Triumph to Tragedy : "In the sad economic history of Argentina during the last half-century, the past decade encompassed a remarkable transition. Rising from the ashes of yet another episode of economic chaos and hyperinflation at the end of the 1980s, the surprisingly orthodox policies of the new Peronist President, Carlos Menem, brought a decisive end to decades of monetary instability and launched the Argentine economy into four years of unusually rapid and sustained expansion. Those economic policies... featured a hard peg of the Argentine peso at parity to the US dollar, backed by the Convertibility Plan, which strictly limited domestic money creation under a currency board like arrangement. Many doubted whether the new policy regime would survive, especially as tensions rose during the tequila crisis initiated by the Mexican devaluation of December 1994. But, it did survive; and after a sharp recession in 1995..., the Argentine economy resumed rapid growth from late 1995 until the spillover effects of the Brazilian crisis hit Argentina in late 1998. Indeed, with most of the miracle economies of emerging Asia collapsing into crises from mid-1997 to early 1998, Argentina became the darling of emerging-market finance—able to float large issues of medium and longer maturity debt on world credit markets at comparatively modest spreads over US Treasuries. And, in the official international financial community, especially the International Monetary Fund, many of Argentina's economic policies were widely applauded and suggested as a model that other emerging-market countries should emulate—international approval that was dramatized by President Menem's triumphant address to the IMF/World Bank Annual Meeting in early October 1999.

Barely two years later, Argentina's decade long experiment with hard money and orthodox policies has ended in tragedy—the depths of which are not yet fully known. The economy is well into its fourth year of recession and rapidly spiraling downward. Most of the banking system has effectively been closed since the beginning of December 2001, and there is no indication of when it may resume something approaching normal operations. The exchange rate peg is gone, and the peso is trading at substantially depreciated exchange rates against the dollar. Economic and financial chaos banished from Argentina since the hyperinflation of 1990 have returned, and there is a real threat that hyperinflation itself may soon return... With formal default on its sovereign external debt, Argentina has been transformed within barely two years from the darling of emerging-market finance to the world's leading deadbeat."

Argentina is in the midst of tragic financial and economic collapse. While the forces and causes involved are many and complex, the bottom line is that its once acclaimed Monetary Regime has imploded, with Argentina left today without a functioning Credit system and resulting financial chaos. There is one critical lesson to be taken from the Argentina experience: it is a grievous policy error to adopt a Monetary structure that is unsustainable over the longer-term and vulnerable to implosion, no matter how immediately expedient. When it comes to Monetary policymaking, conservatism must overrule seductive experimentalism. It is experiments that can fail spectacularly and end in catastrophe. Surely, virtually everyone would today view any analysis underscoring the parallels of the U.S. financial system to Argentina's as wild extremism, but please hear me out on this one. Both Argentina and the U.S. saw fundamental changes occur to their respective domestic Credit systems. These changes, interacting with wildcat global speculative finance, nurtured Credit Bubbles that then evolved into precarious and Untenable Monetary Regimes. The critical issue in the U.S. has moved well beyond that of asset Bubbles (that was the issue prior to 1998). Most regrettably, the focus now must be directed to the unsustainable nature of a U.S. Monetary "experiment" run amuck.

It is my contention that the U.S. Credit market has developed into the "safe haven" (the last bastion of speculative excess) for the global financial players - with profound ramifications for U.S. financial system and economy stability. After a long series of financial crises elsewhere, and with the Fed's and GSE's overly successful efforts to sustain the evolving U.S. "structured finance" Regime, U.S. securities markets became the "darling" of the speculating community. Wild excesses throughout "structured finance" became the key transmission mechanism distorting both financial markets and the economy. Ironically, the fragility of the dysfunctional global financial architecture only played directly into the hands of the expanding U.S. Credit Bubble and the evolving "structured finance" Monetary Regime.

Dr. Mussa's paper adeptly elucidates how Argentina's pegged currency board regime played an instrumental role in sustaining the country's Credit system during the Mexican "tequila" crisis that erupted at the end of 1994. Indeed, Argentina's resiliency in the face of crisis set in motion powerfully self-reinforcing and seductive financial processes - proving a key evolutionary event. Although the IMF was initially (justifiably) very skeptical of the "desirability and viability of the exchange rate peg" (put in place during April 1991), the Fund strongly supported Argentina's efforts to maintain the regime during the Mexican crisis. Then, "after successfully navigating the strains of the tequila crisis, Argentina was widely seen as one of the most successful emerging economies... Private financial markets roared their approval... by financing large amounts of Argentine borrowing at attractive spreads..." With Argentina's Monetary Regime validated, global players emboldened by the Mexican bailout, and with global liquidity aplenty, international finance flooded in. As time went on, Argentina was adopted as the favored emerging market, while previous IMF concerns as to the long-term viability of its pegged currency system dissipated. In fact, the Fund became a strong proponent, and Argentina's policies were presented as a "poster child" of an IMF success story by an organization under intense criticism for its policies elsewhere.

In an environment of endemic global financial disorder, there are complex forces and unintended consequences. The powerful wrecking ball of excessive liquidity and destabilizing "hot money" speculation has a propensity of swinging around in a manner that leads to the most damage - drawn like a magnet directly to financial structures and government policies with the greatest inherent inflationary biases. So, against a global backdrop of over liquefied financial markets and intense speculative impulses, Argentina's Monetary Regime (that very effectively constrained domestic inflationary Credit creation) had major unintended consequence of inciting a flood of foreign finance. In this regard, I would like to make two points that are, as well, pertinent to the current U.S. predicament. First, the inflationary manifestations of this foreign-sourced liquidity were not of the garden-variety pressures on consumer prices (money was not coming to acquire food and toothpaste!), and were thus off the radar screen of policymakers and financial players. The government was happy to borrow, and global financial players were ecstatic to play government bonds dominated in dollars with a significant spread to U.S. interest rates. Second, individual financial systems, economies, and political and social systems have unique characteristics, and thus will respond to various inflationary forces based on their own inherent predispositions and biases. In the U.S., financial, political and social forces impart a significant inflationary bias throughout household mortgage finance. The strong American sentiment against federal government deficits is nonexistent when it comes to mortgage debt creation and, as we have witnessed, these inflationary pressures have only thus far been emboldened by heightened financial fragility. Argentina, on the other hand, has historically a strong proclivity of excess (inflationary bias) throughout its powerful system of governmental finance.

From Mussa: "...in the management of its fiscal affairs, the Argentine government is like a chronic alcoholic - once it starts to imbibe the political pleasures of deficit spending, it keeps on going until it reaches the economic equivalent of falling down drunk." Today, the Argentina government is hopelessly in default and previous borrowing excesses are conspicuous and rightfully under attack. But how was the "chronic alcoholic" capable of such reckless activities right before the watchful eyes of the IMF and sophisticated financial players? Who in their right mind was selling (on Credit) all the booze to the drunk? Here again, please ponder the U.S. debt predicament (particularly in the mortgage and consumer area) when analyzing Argentine government deficit statistics. From Dr. Mussa's paper, we see that "consolidated government" deficits increased from 0.2% during 1993, to 1.7% in 1994, 3.4% in 1995, 3.3% in 1996, and 2.1% during both 1997 and 1998. On the surface, these numbers do not look especially alarming, and apologists were at the time easily capable of explaining them away. Yet, over this period total public debt as a percentage of GDP did rise from 29.2% at the end of 1993 to 41.4% by the end of 1998, although again apologists could have created logarithmic charts, myriad statistics, or other devices to paint this problematic deterioration in a positive light (as we see today in the face of flagrant US consumer and mortgage debt excess). But even at 41.4% of GDP, the Argentine debt load did not appear especially troubling, especially when compared to other emerging markets (that are often above 50% and sometimes go as high as 100%).

But the nub of the issue is that, with nominal GDP expanding by 26% over five years, total public debt quietly surged a whopping 79%. What should have been an obvious Credit Bubble - and could have been made clear by a simple chart of government debt growth - was in reality disguised by "impressive" GDP expansion. Importantly, the government debt market became the key transmission mechanism of Credit inflation that was fueling buoyant financial markets, system-wide easy Credit availability, self-feeding borrowing and spending, and consequent significant GDP growth. On the surface, all looked fine. Although rapid spending and income growth were in reality inflationary manifestations, they were at the same time (as they are today in the U.S.!) the key variables identified as evidence of economic well-being. These seductive forces imbued perceptions of a healthy expansion that only incited additional foreign finance (Credit excess begets Credit excess). Plentiful liquidity allowed the government to spend freely and to privatize ("monetize") state assets, while the perception of endless liquidity took firm hold. With ultra-easy Credit availability, Argentine governments, households, and corporations borrowed freely in foreign currencies and a Bubble economy expanded with all appearances of a sound and sustainable prosperity. Confidence in the new Monetary Regime ran high throughout, with unsustainable borrowing and spending rising accordingly. It was a textbook Credit Bubble fueling a Bubble economy and, as is typical, there was a key new "wrinkle" that made it all somehow appears reasonable.

As Dr. Mussa points out - and this is a critical point in regard to Argentina's currency board and the U.S. "structured finance" Monetary Regime - new Regimes generally perform very well initially. The vaunted features of the system attract foreign finance, while a revived Credit mechanism fuels expansion and the positive feedback of changing market perceptions. This initial success naturally foments disregard for longer-term sustainability issues, while discrediting and nuzzling the cautious and more vocal "naysayers." The initial financial players are rewarded handsomely for accepting the risk of the new Regime and - especially in this extraordinary environment - performance chasing speculative finance arrives in waves. Monetary disorder is imparted, and the character and stability of the system is forever altered. Importantly, a Regime with the purpose and appearance of delivering stability creates the exact opposite. Dr. Mussa makes another key point when writing, "shrewd debt management and careful exploitation" of the market environment by Argentine financial officials played a key role. Indeed, global speculative finance will gravitate toward what it perceives as especially competent borrowers, and we have witnessed this dangerous dynamic play out to an historic extreme with Fannie Mae, Freddie Mac, and U.S. "structured finance" generally.

From Dr. Mussa: "With the collapse into financial crisis of many previously successful Asian emerging-market economies in 1997-98 and the developing difficulties in Russia and Brazil, Argentina stood out as one clear success story." Positive market perceptions were shaped by various factors, including an economy not significantly impacted by the global deflationary forces ravaging manufacturing-based economies; a banking system that had been largely taken over by well-capitalized banks from the U.S. and Europe; and a central bank determined to maintain convertibility under the auspices of strong IMF and global economic community support. In the grand scheme of things, and especially considering acute problems elsewhere, things looked ok in Argentina. Indeed, the country was able to raise large amounts of foreign denominated debt with the post-LTCM over-liquefied markets in 1999/2000 despite a weak domestic economy. Interestingly, Dr. Mussa writes, "Until quite recently, perhaps as late as mid 2001, it was not clear that the Convertibility Plan was doomed to collapse in a catastrophic crisis." Here's were we have a problem with conventional thinking.

Many economists today seems to take the view that "if only Argentina would not have run big government deficits" the rapidly expanding Argentine economy was on the path of sustainable prosperity. This misses the critical point: destabilizing speculative financial flows were poised to fund Credit excess one way or the other; it was only a case of in what sectors and to what negative consequence. Throughout SE Asia, malinvestment throughout the manufacturing sector was the most extreme inflationary manifestation emanating from excessive foreign finance. In countries such as Argentina and the U.S., with higher labor costs and generally uncompetitive currencies, the "hot money" would play differently with divergent consequences. For Argentina, the government debt market would provide the key mechanism for channeling liquidity into the financial markets and economy, while for the U.S. such processes would be (especially post-tech Bubble) increasingly dominated by mortgage and consumer finance. The key is to appreciate that over time these flows impose distinct Monetary processes, and any contraction or reversal of this finance can have profound ramifications for the functioning of a liquidity-dependent financial system and economy. In Argentina, foreign flows financing government spending was the key dynamic fueling a self-feeding economic Bubble. Pondering "what ifs" in regard to the sustainability of the Argentine boom if not for the ineptness of government fiscal policy, is in the same vein as analysts down the road believing that the U.S. boom could have been sustained indefinitely if only consumers had not taken on such huge mortgage debt.

In Argentina, no one was willing to contemplate a reversal of foreign flows. And the greater the accumulation of foreign liabilities, the more the Monetary Regime became "too big to fail." In the U.S. today, to question that all this foreign-sourced finance might someday tire of accumulating U.S. financial claims (and may even decide to sell a few) is tantamount to lunacy. Disregard of the obvious is a rather strange dynamic of our time. After all, we have by now seen such processes in action again and again, and it should be very clear to policymakers that attentive speculators are keen to aggressively play above-market yields, various spreads, or any other "trade" made attractive by government policies. It is similarly not rocket science to appreciate that such flows are specifically not sustainable and will, in fact, generally reverse abruptly and problematically at some point. Clearly, it is common knowledge that various derivative products (defaults swaps, currency hedging vehicles) are created specifically to protect the "hot money" for the day when the game changes. Meanwhile, economic policymakers seem stubbornly determined to disregard that these dynamics are a key factor for these recurring booms that are followed by illiquidity and busts. And while there may be some debate as to whether the availability of derivative "insurance" incites more aggressive speculation during the boom (we argue strongly that it does!), there should be no doubt how destabilizing these types of derivatives are when crisis erupts.

Our concern with Argentina was focused specifically on the inevitability of a reversal of foreign flows and the impact this would have on acutely fragile debt structures and an economy with little wherewithal to generate sufficient cash flows. Recognizing how financial players were likely acquiring derivative protection against the increasing probability of a breakdown of the pegged currency board system, the risk then clearly became that a serious market dislocation/collapse would inevitably develop the day the authorities were forced to float the peso. As we saw throughout SE Asia, Russia, Brazil, and Turkey, when the "hot money" heads for the door and the derivative players are forced simultaneously to aggressively sell the underlying currency (dynamic hedging) to hedge exposure on the derivative "protection" they have written, collapse is virtually assured. Authorities, hoping to avoid such a scenario at all cost, in actuality nurture dynamics that over time ensure that speculative holdings and corresponding derivative exposure become so enormous that there is simply no avoiding serious market dislocation when the inevitable reversal comes. And this gets back to last week's discussion on the Fed's mistake in associating bursting Bubbles with collapsing confidence. The problem in Argentina was not a short-term break in confidence, but an unavoidable collapse assured by enormous flows of destabilizing speculative finance and resulting maladjustments. There was no avoiding the consequences of acutely fragile debt structures and extreme financial and economic imbalances that, ironically, evolved from a Monetary Regime that was adopted specifically to ensure stability.

Somewhere along the line, it should have been clear to the Argentine authorities, the IMF, and the international banking community that the peso currency board system had evolved from a mechanism assuring domestic price stability to one inciting dangerous financial and economic instability. While domestic consumer prices remained in check, the Monetary Regime became a lightening rod for fostering an explosion of unstable foreign-sourced finance on one hand, and non-productive debt on the other. This is a precarious combination. But as long as additional finance was forthcoming, the economic wheels kept turning, and the seductive accumulation of these financial claims did not appear problematic. In fact, a crucial dynamic evolved where the larger the accumulation of this non-productive debt, the greater the underlying financial fragility. The point of no return had been passed, only forcing total commitment from the Argentine government, the IMF, and the global financial community to try to maintain a self-destructing system. This is another case of the ossification of dysfunctional monetary processes. Once commenced, no one is willing to face the medicine, and the whole process goes to such egregious extremes to end only in catastrophic collapse.

Total commitment to sustaining an unsustainable system did work to keep the "hot money" in the game a while longer. Only when the foreign flows eventually reversed and liquidity necessarily waned did it then become a most critical issue that there was little economic wealth producing capacity underpinning all the accumulated debt. It is important, and especially pertinent to the current U.S. predicament, to appreciate that Argentina's perceived advantage (to global financiers speculating on interest rates and spreads, as opposed to seeking true economic profits) of a stable currency and being relatively immune to the woes afflicting manufacturing economies came back to haunt. Not only had this played an instrumental role in Argentina accumulating enormous foreign liabilities, but when the Bubble eventually burst the economy was beset with not only huge debt but with little means for generating cash flows. The creation of financial claims (debt) did spur spending and GDP during the boom, but quickly became the system's Achilles' heel with the inevitable bust. The manufacturing economies throughout SE Asia had suffered similarly disastrous currency and economic collapse, but at least they had manufacturing capacity that, in concert with sharply devalued currencies, provided the means for economic and financial recovery. The non-productive character of Argentina's debt manifested in what should be appreciated as a panic run on Argentine financial claims.

These dynamics go right to the core of our deep concerns about the U.S. Credit Bubble and the evolution of an Untenable "structured finance" Monetary Regime. For some time, the "de-industrialized" U.S. economy has won the undivided affections of global speculative finance by default and otherwise. A new Monetary Regime was covertly adopted - with the capacity for producing endless "safe" and liquid top-rated agency debt, unlimited "Triple-A" rated mortgage and asset-backed securities, etc. - ensuring sufficient Credit to stimulate spending and the appearance of a stable and resilient economy. The aggressive U.S. financial sector could both create its own liquidity and incite what at times has seemed insatiable demand for the dollars flooding the global economy. Somewhere along the line, this Regime became much too big to fail, and this fact only emboldened the global financial community that looks confidently to the Fed and GSE to guarantee liquidity. The upshot has been an unprecedented explosion of non-productive debt, along with an underlying maladjusted economy with little capacity for generating sufficient cash flows when these speculative flows inevitably reverse. Like Argentina, we see in the U.S. all the necessary ingredients for an inevitable run on U.S. financial claims.

As discussed last week, the Fed has made a momentous error in associating a crisis in confidence with faltering market liquidity. Managing marketplace liquidity and market perceptions has become the self-appointed mandate of the Greenspan Fed. The irony is that providing assurances of liquidity to the marketplace - with the intention of ameliorating any sudden crisis in confidence/bursting of Bubbles - the Fed and GSEs only ensured destabilizing speculation and an edifice of unsupportable non-productive debt throughout the entire system. The speculators should live in constant fear of illiquidity - they grew fearless. The derivative players should be operating cautiously, cognizant that their models must make the fallacious assumptions of continuous markets and liquidity. The Fed has assured the derivatives market that the Fed has the means of righting wrong assumptions. These are huge, critical mistakes.

It is very interesting today that with the collapse of the telecom debt sector there has not been a more serious problem for the Credit derivative players. We certainly suspect that there are major problems in this area that will surface at some point, but that's another issue. Today, especially after surviving the collapse of the technology Bubble, the perception has only been hardened that derivative markets do mitigate systemic risk as advertised. The belief is that they have been tested successfully. But like Argentina surviving the "tequila" crisis and emerging market meltdown of 1997 through 1999, we think the resulting complacency is misplaced. In fact, "success" has similarly bred disaster.

The U.S. financial system suffered a brief liquidity crisis when the system was "seizing up" back in October 1998. But since that time an unrelenting flood of GSE and "structured finance"-induced liquidity has besieged the system. When players in Credit and default derivatives have been forced into the market to dynamically hedge (sell short) their exposure to the likes of Enron, Tyco, Global Crossing, Worldcom, or other telecommunications bonds, they have generally enjoyed the luxury of very liquid financial markets. Derivative players, speculators, and investors that were selling equities had the luxury of finding buyers. Companies that found that they were at the brink of problems rolling short-term debt amazingly enjoyed the luxury of virtually insatiable demand for longer-term debt issues. We don't expect these luxuries to continue for much longer, and we see the current conviction that the Fed will always maintain control over systemic liquidity as extremely dangerous. In Argentina, while foreign finance was forthcoming, the government bond market had all appearances of sustainable liquidity. This illusion, however, abruptly evaporated into devastating illiquidity and market dislocation.

Our concern is that the U.S. system is at increasing risk of commencing similar market dynamics, with the likelihood that this process would eventually evolve to include the area that has enjoyed the greatest excess and, consequently, has been the most instrumental mechanism responsible for systemic liquidity - "structured finance." We think the Fed is given too much credit for creating liquidity, and the GSEs and U.S. financial sector not enough. The very financial sector that has been responsible for keeping the U.S. system awash in liquidity since 1998 has built up an incredible edifice of unprecedented financial leverage, speculative positions, and fragile debt structures. And while the resulting liquidity has played the major role in accommodating the deleveraging and derivative-related selling associated with the collapse of the technology Bubble, the residual has been an only greater degree of leverage and derivative exposure associated with the explosion of GSE debt, mortgage and asset-backed securities, CDOs, and convertible securities.

It is our view that the system has not yet been tested, and that this test will come when speculative positions are reversed, demand wanes for U.S. securities, and liquidity attempts to flee dollar assets. Recent developments with the dollar and the technology sector raise the possibility this test could be forthcoming. This would be the scenario that would find the leveraged speculators and derivative dynamic hedgers fighting for vanishing liquidity. This is the scenario we have feared for some time; that has been delayed for some time; that may be forestalled for some time; but is certain to be one hell of a problem at some point in time. We fear that the unfolding collapse in the technology sector could prove an ominous harbinger of things to come for our nation's Untenable Monetary Regime.

Appendix of Notable Fed Quotes for the week:
"The question is whether or not current policy is favoring debtors to the disadvantage of savers. Well, in some respects I think that's true. We are favoring debtors in the sense that with interest rates low it makes it more attractive for people to borrow. At the same time, because interest rates are low, those who are in fixed income - interest income - they are not doing as well. I think that's probably true. I'm not convinced that that should play a role in monetary policy though. We have to be very careful. We can't have too many objectives. If we have too many objectives and worry about savers, or we worry about debtors, or we worry about people in one part of the country or another part of the country. You can't worry about everything. You've got to realize that monetary policy is a very blunt instrument. It can't do many different things in terms of having objectives. And our objective is quite clear: Our objective is low inflation, because we think that that is what best to pursue that will ensure the longer-term prosperity in the U.S. economy."   Robert Parry, president of the San Francisco Federal Reserve Bank, April 23, 2002, answering a question after his talk at Gettysburg College

Alan Greenspan "...I think that it is evident that productivity has been really behaving quite remarkably in the past six months. As you know, it went up at more than a 5% annual rate in the fourth quarter in the United States. And depending on how the GDP figures come out this Friday, we are looking at another very substantial increase for the first quarter. This is suggesting that something quite fundamental has happened in the United States over the past half decade and more... and I think that this bodes well for the longer-term outlook for economic growth in the United States largely because all the evidence that we currently have suggests that we really have not worked our way through the various extraordinary amount of potential backlog of unexploited capital investment opportunities in the high tech area. This suggests that all other things equal the growth rate is likely to be quite measurably stronger than it was, for example, over the quarter century prior to 1995. But it's difficult to make judgments about how something as dynamic as the current system is likely to evolve. ...Clearly we see that information technology has very significantly removed a good deal of the inventory imbalances in which in previous periods had been such a major factor of business cycles. But I also pointed out, we are moving towards an increasingly conceptual oriented economy, one in which... the physical weight of the GDP is very marginally increasing. And that virtually all of the increased real value added in our economy is conceptual by nature. And as I indicated earlier, companies like Enron - whatever they did wrong - were developing into the most conceptual oriented type of organization and indeed the market value of the firm was essentially capitalized reputation... That suggests that one cannot collapse the economic value of a major enterprise such as a steel company or a petrol-chemical plant, irrespective of what people who are running it are doing. When you are dealing with conceptual values and reputation as the cause of value added, you are creating a system which is vulnerable to a very significant adjustment, as we have observed in the Enron case. So I am reluctant to say that the degree of vulnerability over the long run has been significantly and unalterably altered by what has been going on in the major increases in technology in the United States. But I think it is safe to say, that unless we are hit by an external events which we don't anticipate, it's very evident that there is something fundamentally improved in the American economy and... We were not really sure until we went through a full business cycle - which we clearly have - and seen how productivity and the underlying capital structure evolved. And so far I must say that it is really quite impressive."  - Alan Greenspan, April 22, 2002, speaking to the Institute for International Finance.

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