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Dieing a Death of a Thousand Cuts

Exhisting Home Sales
Exhisting Home Sales Average (Mean) Price
Personal Income
Personal Consumption Expenditures

This week offered no respite to a weak stock market. For the week, the Dow and S&P500 declined 2%. The Transports and Morgan Stanley Consumer indices were unchanged, while the Morgan Stanley Cyclical index dipped 1%. The Utilities dropped 3%. Selling was prevalent in the broader market, with the small cap Russell 2000 and S&P 400 Mid-Cap indices declining 1%. Technology stocks again were hit hard, with the NASDAQ100 dropping 4%, the Morgan Stanley High Tech index 3%, and the Semiconductors 5%. The Street.com Internet index declined 4% and the NASDAQ Telecommunications index dipped 3%. The major Biotech index shed 3%. Financial stocks were under pressure, with the AMEX Securities broker/dealer and S&P Bank index declining 3%. Despite bullion rising $5.50, the HUI Gold index was basically unchanged for the week.

The Credit market continues to celebrate financial fragility. For the week, the 2-year Treasury yield declined 9 basis points to 3.14%, and the 5-year yield declined 10 basis points to 4.35%. The 10-year Treasury yield declined 10 basis points to 5.05%, while the long-bond saw its yield dip 5 basis points to 5.62%. The December 3-month eurodollar futures contract saw its yield drop 10 basis points to 2.91%. Benchmark mortgage-back yields generally declined about 8 basis points (to the lowest yields since February), while the implied yield on agency futures dropped 10 basis points. The benchmark 10-year dollar swap spread narrowed one to 51, while the spread to Treasuries for Fannie Mae's 5 3/8% 2011 note also narrowed one to 51. The dollar index dropped 1% for the week.

The May Chicago Purchasing Manager's index of 60.8 was much stronger than estimates of 55. The index jumped 6 points during month and is up 19.4 points in five months to the highest reading since April 1999. New Orders surged to 65.6 from 59, the strongest reading since April 1999. Production jumped almost 10 points to 65.6, the highest since December 1995. Prices increased almost 3 points to 58.3, and are up 17.6 points in four months to the highest reading since March 2001. Rising 1.2%, today's report of stronger than expected factory orders was the strongest reading since October. Non-defense capital goods orders excluding aircraft increased 4%. The University of Michigan consumer confidence reading of 96.9 was the highest reading since December 2000.

April personal income and spending data were reported basically in line with expectations. Once again, spending growth (0.5%) surpassed income growth (0.3%). The detail is much more interesting than the headline numbers. Some of the analytical confusion regarding income growth relates to the use of wages as opposed to total income. Wage disbursements are relatively stagnant, up 1.5% y-o-y and rising at a 1.9% rate year-to-date. Interestingly, while manufacturing wages declined 4.3% y-o-y (and flat y-t-d), services wages were up 2.7% (1.7%) and government wages increased 5.8% (6.1% pace y-t-d). Wages may be growing slowly, but total personal income has increased at a 5.3% annual pace to far for 2002. The difference is largely explained by the 12% rate of growth for transfer payments so far this year. Since one would expect spending to be impacted by total income, it is not difficult to explain that total personal spending has been growing at a 6% rate thus far for 2002. Spending gains are broad-based, with non-durable spending up 8.3%, durable 5.1%, and services up 5.0% y-t-d.

The National Association of Realtors reported stronger than expected existing home sales Wednesday. At an annualized rate of 5.79 million units, it was the third strongest report on record behind January and February. Sales were up 9.6% from last year's very strong level, with average (mean) prices up 8.8% y-o-y to $195,700. Sales were strong across the nation, with y-o-y transactions up 11.1% in the Northeast, 9.5% in the South, 3.3% in the Midwest, and 4% in the West. Average prices were up 9.7% to $203,000 units in the East, 13.1% to $161,000 in the Midwest, 5.8% to $178,000 in the South, and up 8.4% to $258,600 in the West. To put the total number of sales in perspective, it was up 38% from pre-Bubble April 1997 and 82% from April 1990. April's annualized volume of 5.79 million units compares to the average 3.67 million for the first eight Aprils of the nineties.

Yet, the scope of the mortgage finance Bubble is best illuminated by the "calculated transaction volume" (CTV) calculation - the best indication of the degree of mortgage credit expansion. Multiplying April's average price by annualized transactions we get CTV of $1.133 trillion. With prices up 8.8% and volume up 9.6%, CTV was up a whopping 19% form April 2001. April's CTV was up 31% from April 2000, 30% from April 1999, 47% from April 1998, 84% from April 1997, 88% from April 1996, and 192% from the CTV of $432.6 billion during April 1995.

From the Florida Association of Realtors: "Florida home sales rose 17 percent in April compared to home sales in April 2001, making it the largest monthly increase since June 1999." Year-over-year median prices were up double-digits in Daytona Beach, Fort Lauderdale, Miami and Naples. The Illinois Association of Realtors reported April sales up 7.6% y-o-y, with median prices up 8.5%. "The housing market remains very strong, especially compared to other sectors of the state and national economies." "The preliminary year-to-date total for statewide, existing, single-family home sales" is up 12.3% from comparable 2001.

But when it comes to housing Bubbles, our focus will continue to be California. The Golden State real estate Bubble has now firmly moved into the dangerous speculative blow-off stage. Throughout the state there is virtually a buyers' panic, with lenders continuing to provide extremely accommodative lending terms. This is precisely the type of dynamic that destroys financial systems. Wednesday the California Association of Realtors (CAR) reported that April sales jumped 29.8% y-o-y, while the median home price surged a remarkable 26.1%.

From the CAR president Robert Bailey: "Residential real estate in California, particularly in the San Francisco Bay Area, continued to rebound aggressively last month compared to 2001. Sales in the San Francisco Bay Area increased 73 percent in April compared to a year ago and surged nearly 120 percent in Santa Clara. At $321,950, the median price of a home in California topped $300,000 for a second time last month. Both sales and the median home price hit new records in April. With only a two-month supply of homes for sale throughout the state, there simply isn't enough inventory available to meet the demand for homes."

The median price jumped $15,330 during the month, or 5.2%, and is up a stunning $66,637 during the past twelve months. Condo prices were up 19.9% y-o-y, with sales volume up 35%. The state's inventory of single-family homes dropped to 2.6 months from last April's already thin 3.8 months. Housing inflation is strong throughout the state, with y-o-y prices up 21.1% in Los Angeles, 14.8% in San Diego, 21.7% in Santa Barbara, 27.2% in Palm Springs/Lower Desert, 14% in Northern California, and 14.4% in Sacramento. I often read bearish economic analysis holding to the notion of a "shortage of worthy borrowers." Such analysis is not particularly useful in the midst of a mortgage finance Bubble with inflating home equity. The average California homeowner is today experiencing basically enormous tax-free gains to use as "equity" for purchasing a larger home with a bigger mortgage, or extracting equity for consumption or investment. As we have discussed repeatedly, asset Bubbles are seductively dangerous as Credit excess begets rising asset prices, greater collateral value to borrow against, and only more intense demands for borrowing. We are watching these dynamics play out in historic fashion in California and elsewhere.

From Daryl Strickland's article in Tuesday's Los Angeles Times. "In Southern California, where there are far more house hunters than houses, builders with homes to sell can virtually pick a number - and someone will pay it. For properties that sell for less than $500,000, builders have too many potential buyers, no matter how high they raise the prices, said Jeff Meyers, who heads industry consulting firm Meyers Group. 'Builders can't find the top right now,' he said. Prices have spiraled upward so quickly... At the Meridian, an oceanfront condominium complex in Long Beach, prices for a popular floor plan grew to $436,000 in March, up from $316,000 a year ago, a 38% increase. At Twilight Vistas, a community of single-family homes in the Santa Clarita Valley, costs surged 37% for some models to $550,000 from $402,000 a year earlier. And at the Rose Maria Condominiums in Placentia, one floor plan climbed to $189,000 from $149,000 a year earlier, a 27% increase."

And while it was popular to dismiss January and February's booming existing home sales as a final rush to beat rising mortgage rates, April data proves that view complacent at best. The LA Times quoted a major builder: "In the last three months, demand has become steadily better each month." From Bruce Karatz, chairman of building behemoth KB Homes: "These are the kinds of things over my 30 yeas in the business that have rarely occurred before." And, alarmingly, (from the LA Times) "About a one-month inventory of new single-family homes, condominiums, and townhouses exists at the current selling pace in Southern California." It's going to be a hot summer...

The contemporary U.S. Credit system is truly a modern marvel. As we have explained repeatedly, the American financial sector enjoys the capacity for creating demand for its own liabilities. We cannot overstate the importance of this financial evolution, or the negative consequences if it proves unsustainable. It is also today worth pondering the ramifications of this unharnessed capacity of creating dollar claims in a global environment increasingly suspect of dollar assets. The issuance of financial sector liabilities creates the liquidity (purchasing power) for the issuance of additional new securities or liabilities. As long as demand remains robust for these new liabilities, the financial system maintains capacity to extend Credit irrespective of "savings." And with the U.S. financial sector - specifically the GSEs, Wall Street "structured finance," and money market fund intermediation - having mastered the production of seemingly "risk free" and liquid liabilities (i.e. "money"), there is basically insatiable domestic demand for new monetary liabilities.

When marketplace tolerance for risk is increasing (as was the case during most of the first quarter), the financial sector will gladly accommodate by issuing mortgage-back securities, junk bonds, long-term corporate debt, converts, and so on. Strong market demand will entice companies such as GE, Fannie Mae, or even Caterpillar, to issue bonds and pay down commercial paper. Footprints of such liability management activities were left in the data, as debt issuance accelerated in the face of broad money supply stagnation. In such a situation, to focus on money supply without careful consideration for general debt issuance and liability management activities leaves one prone to analytical error.

As we have witnessed previously and saw play out aggressively post-WTC, the U.S. financial sector (especially the GSEs and "structured finance") is conditioned to react to heightened financial stress with aggressive expansion. Wide spreads and/or the likelihood of Fed-orchestrated rate declines entice key financial institutions to acquire risky financial assets while issuing monetary liabilities (banking system deposits or deposits intermediated through the money market fund complex). Such a "reliquefication" provides acute demand for risky financial assets, while creating large amounts of "safe" liabilities to be held by "savers" and various market participants. Importantly, the financial sector's aggressive accumulation of risky financial assets (commercial and consumer loans, mortgage-backs, etc.) works to stimulate spending in the real economy, which over time becomes self-reinforcing. The recovering financial markets and economy reduce risk aversion, allowing borrowers (generally corporations and the financial sector) to then exchange the short-term liabilities ("money") issued in large quantities during "reliquefication" for longer-term debt issues. These dynamics are key to appreciating money supply fluctuations and, more importantly, why the U.S. Credit system has thus far easily succeeded in sustaining Credit excess.

When bank lending dominated the Credit creation process, bank deposits (money) were the prominent residual of lending. "Money supply" growth was then a good proxy for the general Credit environment, thus a narrow focus on currency and deposits provided the key variable for gauging inflationary conditions. Money was also generally backed by economic wealth-producing assets. Today, in the age where myriad lenders, financial players, and marketable securities dominate the Credit system, we must take a very broad view of the issuance of additional financial claims that create the purchasing power for a broad range of goods and services, and often most importantly, real and financial assets. I read analysis recently defining inflation as an increase in the money supply. This is too simplistic and not necessarily accurate. Today, the change in quantity of a narrow range of "safe" liabilities ("money" supply) is more an indication of general market risk aversion than it is the creation of inflationary purchasing power. It is Credit growth - the creation of additional purchasing power through the issuance of additional financial liabilities - that leads to various inflationary price distortions. These inflationary manifestations continue to be most prevalent in the asset markets, with the residual an ever-enlarging pool of suspect dollar claims.

I often write that contemporary finance is specifically not conducive to a properly functioning free market pricing mechanism. For one reason, the capacity for the U.S. financial sector to create demand for its own liabilities throws traditional supply and demand relationships for available finance completely out the window. Historically, interest rates were determined in the marketplace as interplay between the demand to borrow and the limited supply of money available to be lent. Money was the critical medium of exchange for most transactions, and the supply of this medium was limited by the quantity of precious metals or, later, by reserve and capital requirements. Heightened borrowing demands for a limited quantity of money pressured interest rates. Rising rates coupled with bankers' limited capacity to lend acted to temper Credit expansion. The system, while certainly not immune to boom and busts, at least had a mechanism of self-regulation and correction. For much of history, the resulting outflow of gold played an instrumental role in regulating domestic lending excess.

Today, there are no constraints on the creation of monetary liabilities - "money" that enjoys basically insatiable demand. In addition, the creation of a wide range of financial assets encompassing "Credit" has replaced narrow money (currency and bank deposits) as the "medium" for consummating the majority of transactions (especially in the asset markets). The U.S. dollar has for some time been immune to typical consequences of domestic Credit excess, but this should not be taken for granted.

Market interest rates are today predominantly determined by the price participants are willing to pay for securities. As long as Credit market conditions are conducive to leveraged speculation, there is unlimited availability of borrowings for the acquisition of financial assets, meager savings notwithstanding. We saw this dynamic in full-force during the technology Bubble, as unprecedented demand for margin borrowings was easily accommodated by the financial sector with little pressure on the cost of finance. Even the distorted broker call market in the late 1920s saw rates rise significantly in response to aggressive borrowings.

In today's market environment dominated by leveraged speculation and "spread" trades, fixed-income security prices are largely determined by the spread to the cost of available funds. The central financial planners in Washington (the Federal Reserve, Treasury, Fannie Mae, Freddie Mac, the Federal Home Loan Bank System, etc.) determine the cost of funds and liquidity conditions along a spectrum of "safe" assets, with various market interest rates simply a spread to "risk free" rates. As we are witnessing currently, as long as the Federal Reserve sets short-term rates (artificially) low and the GSE are content to aggressively expand their holdings of financial assets, market rates can remain disconnected to even unprecedented demand for mortgage borrowings. Interest rates no longer function as a stabilizing force. Indeed, a strong case could be made that interest rates are categorically destabilizing.

In addition to the general unlimited capacity to create Credit, the market pricing mechanism is further impaired by today's capability of extracting and "Bundling" risk. We saw this dynamic during the telecom debt Bubble, where syndicated bank lending, collateralized debt obligations, Credit insurance, aggressive use of default swaps, Credit derivatives and other sophisticated structures provided the mechanism allowing a disconnect between the demand for borrowings in this sector and what would have typically been a limited supply of loanable funds to a high risk industry. Instead, "structured finance" distorted the pricing, creation, and acceptance of risk in the marketplace, leaving the funding floodgates wide open, with not unpredictable consequences. Unthinkable amounts of risk were easily transferred to thinly capitalized financial institutions and speculators. The market pricing mechanism completely broke down and there was a gross misallocation of finance and resources. The decoupling of risk subverted market forces that would have traditionally acted to temper lending excess to one exceedingly risky sector. The outcome was runaway risk creation on an unprecedented scale.

This type of analysis is today no mere intellectual exercise. The California real estate market is now completely out of control, yet there is (once again) no mechanism at work to provide any modicum of self-regulation or correction. In a replay of the telecom debt Bubble, despite the conspicuous risks unfolding, there remains today simply unlimited availability of inexpensive mortgage Credit. This should be recognized as nothing less than another dangerous breakdown in the risk market. Whether it is at the lower-end where the GSEs are major lenders, or at the upper-end where the banks, S&Ls, and mortgage-backed securities market are the main providers of mortgage finance, mispriced Credit runs rampant. The Fed refuses to raise interest rates, and the marketplace is completely disconnected from the extreme risk now associated with the California mortgage Credit Bubble. Checking rates at Countrywide, a resident of Long Beach, California may borrow $500,000 for a "non-conforming Jumbo" loan with a 30-year adjustable mortgage for 4.75%. Home prices are rising at a multiple of this rate.

We can assume that such a loan would be pooled with others in a trust. The trust would likely acquire mortgage insurance, along with other enhancements and a structure necessary to issue highly rated mortgage-backed securities. Today, spreads between the cost of overnight finance (repo rates and Fed funds) and mortgage-back yields are unusually wide. Speculative interest in these types of top-rated securities today runs high, with seemingly insatiable demand in the marketplace. Mortgage securities are being issued in record quantities, home prices are rising smartly, and the pricing of underlying Credit risk is again being severely underpriced.

National securities markets incorporating "structured finance" work magically in stimulating lending. And as we witnessed with the telecom and energy debt Bubbles, and now with the mortgage finance Bubble, incredible amounts of risky debt can be issued in a relatively limited amount of time, responding to the whims of an unfettered speculative marketplace. But contemporary finance fails miserably at regulating issuance and controlling against excess. Lending excess begets greater excess, and we have witnessed repeatedly how the creation of risk grows exponentially at the late stages of the boom. The Fed allows the financial sector absolute freedom to expand money and Credit to its liking, a process that breeds speculative lending and asset Bubbles. Federal Reserve monetary "management" largely rests on the manipulation of short-term interest rates to stimulate growth in the aggregate economy. But there is a serious problem with manipulating an interest rate as if there is an "aggregate" market. Rather, we operate in a complex system of many individual and often disparate markets. The Fed may today believe it is managing "aggregate demand," when it is in reality sustaining dangerous market Bubbles, exacerbating financial dislocation, and nurturing exponential growth in systemic risk.

It has been central to our analysis that we are today at an historic crossroads for the U.S. financial system. The seductive technology Bubble (and its powerful magnetic qualities for global flows) has burst and not even the most extreme Fed accommodation can provide a new lease on life. At the same time, there is little room for the Fed to use interest rates to incite continued foreign flows. Alan Greenspan has played this card too aggressively in the past, and we don't believe this aspect of the Fed's current dilemma receives its deserved attention. We are tempted to proffer that historians will look at the past several years as an aberrational period. Only a global Bubble of leveraged speculation in U.S. Credit market instruments provided the Fed the atypical capacity for attracting global inflows with lower interest rates. It was only this unusual market dynamic that rendered (temporarily) enormous trade deficits unproblematic. Today Fed funds are at 1.75%, and global central bankers are moving away from extraordinary accommodation. Foreign currencies and markets are outperforming. U.S. interest rates are comparatively low, and a declining dollar can wipe out weeks of speculative "spread" profits in a couple of trading hours.

The Fed and U.S. financial sector were successful in fostering a Bubble with the dimensions to sustain Credit excess post-technology Bubble. However, this Bubble is of a different kind. The mortgage finance Bubble is extraordinarily powerful for generating sufficient domestic Credit expansion. It works efficiently to create and diffuse purchasing power throughout the economy and disseminate liquidity throughout the financial system. However, it is not an enticing Bubble to foreign investors or speculators. They will not be rushing into to trade condos in Los Angeles. And what international players are today interested in taking the other side of a Long Beach Jumbo mortgage at 4.75%? Furthermore, unlike during the manic days of the Telecom/technology Bubble, there is not today the enticing prospect of playing the Fed's aggressive easing come the inevitable bust. Perhaps the mortgage finance Bubble is the first to dissuade the foreign players.

Yet, we do have today a quite unusual market dynamic where interest rates seem to be more a reflection of U.S. financial fragility than anything else. Rates barely respond to stronger than expected economic data; they could seem to care less as to booming housing markets and extreme demand for mortgage borrowings; and, curiously, market rates seem to decline along with the dollar. It is not easy to makes sense of such dynamics, although market action again this week is consistent with underlying financial distress. In previous Bulletins we have drawn parallels to the environment in the months leading to the Russian collapse and LTCM debacle back in the autumn of 1998. While it took many weeks for underlying dynamics to surface in 1998, problematic liquidation had been set in motion by significant losses being suffered by the leveraged speculating community. Initially, however, aggressive covering of short positions in the Treasury market and a general flight to safer securities fostered declining U.S. yields and a strong dollar. The U.S. stock market - and especially financial stocks - responded very favorably to this environment in June and through mid-July. The dollar rallied strongly, reaching almost 148 yen on August 14, 1998. It, however, reversed abruptly and traded below 130 by September 11, 1998. The dollar then fell in virtual collapse to 111.85 yen on October 9, 1998, before a Fed orchestrated bailout of LTCM stabilized the system.

There had come a point in August of 1998 when underlying stress began to surface in marketplace, and problematic liquidation of dollar holdings commenced. Swap spreads, having been relatively stable through the summer, began to widen dramatically early in the month. This corresponded with the abrupt dollar reversal. The dollar's changing fortunes were especially troublesome due to the extent of "carry trade" leveraged speculations - borrowing at low rates in, say, Japan or Switzerland to finance holdings of U.S. securities. The stock market began to suffer with faltering systemic liquidity, although there was little appreciation in the marketplace for the possibility of any serious dislocation. Widening spreads, a faltering dollar, and sinking stock prices fed a self-reinforcing liquidation of U.S. securities and a liquidity crisis that came to a head in early October.

It is our sense that we have now entered a more serious stage of an unfolding financial dislocation, although the dynamics are much different than 1998. At this point it is not at all apparent how things might play out. Interestingly, while the dollar has come under significant pressure, U.S. spreads have narrowed as opposed to widened. It does not appear that hedge fund "carry trades" will play the key role they did in 1998. But then again, with U.S. short-term borrowing rates so low, there has not been the overwhelming advantage from borrowing overseas. We have been expecting dollar weakness to occasion the liquidation of U.S. fixed-income securities, but we have yet to see evidence of such. Despite a significant fall in the dollar, we see little indication of faltering systemic liquidity. There is no evidence at this point of any constraints being placed generally on domestic Credit creation. In fact, heightened financial fragility remains a boon to the U.S. Credit market and, thus, is exacerbating the mortgage finance Bubble. Market interest rates are proving, once again, to be destabilizing.

But there are severe financial problems lurking, and the less we see and hear of them the more concerned we are that they may be isolated with the major derivative players. The major move in bullion and gold stocks, along with the break in the dollar, lend credence to this view. After watching the spectacular telecom debt collapse, we are still waiting for recognition of what have been truly unprecedented losses. As we have written in the past, considerable Credit risk has been "bundled" in the derivatives marketplace. There are heavy losses in equity derivatives likely compounded of late by currency losses. The major derivative players have at the same time suffered significant loan losses in the telecom and energy industries (and elsewhere). We have no doubt that there are as well major losses to eventually surface in the area of Credit default swaps and other Credit derivatives. This murky domain aggressively uses offshore "special purpose vehicles" and sophisticated instruments - structures conducive for delaying recognition or concealing losses. While losses do remain hidden, this is nonetheless the type of problem that erodes confidence in the major derivative players and raises concern of potential counterparty and systemic risks. At the minimum, the major derivative players are Dieing a Death of a Thousand Cuts. The loss of blood is taking an increasing toll.

We have also feared that that since 1998 considerable dollar risk has also been "bundled" in the derivatives marketplace - specifically in the swaps market. Foreign holders of U.S. dollar financial claims, instead of selling, have instead had the opportunity to "swap" future dollar cash flows for the cash flows generated by foreign securities. This market functioned wonderfully, as it reduced the need to liquidate escalating dollar holdings by allowing the transference of dollar asset risk to the derivatives marketplace. The swaps market became instrumental for domestic players in the U.S. as well. In the past speculators would short Treasury notes and use the proceeds to purchase higher-yielding securities such as mortgage-backs and agency bonds. The short position in Treasuries (or agencies) provided a hedge against general interest rate increases. The systemic risk associated with this type of speculation being done in enormous excess became conspicuous with the LTCM collapse in 1998. Widening spreads - Treasuries outperforming other securities - led to a self-feeding liquidation of leveraged positions (widening spreads would impart losses forcing leveraged positions to be unwound, leading to additional losses and eventual systemic liquidity crisis).

But the game has changed in profound ways since 1998's near death experience: Players today finance leveraged speculations predominantly in the repurchase agreement and Fed funds markets, and use the swaps market for hedging purposes. This "evolution" has thus far apparently functioned quite well, as it had until recently in the currency markets. Although we are today left very uncomfortable with the thought of only more risk being "bundled" on top of the mountains of risk bundles in the swaps market. Our hunch is that this risk "bundling" gets right to the heart of the unfolding systemic problem. We are firm believers that reckless Credit excess leads to proportional problematic consequences. As the epicenter of risk "mitigation," look to the untested swaps market for inevitable trouble. There is no magic marketplace to hedge systemic risk, despite the myths to the contrary.

We recognize how in the past a speculator would place a bet place on, let's say, mortgage-backs, and hedge interest rate risk by shorting a Treasury note or agency bond. In the event of rising yields, a decline in the price of the security shorted (as the hedge) would generate a positive cash flow. But hedging in the swaps market is a different animal; establishing a hedge only places the swap counterparty at risk to changing market prices. The counterparty then faces the necessity of shorting (or going long) securities - dynamically hedging - to generate the positive cash flows in a rising (declining) rate environment. We especially dislike the systemic risk imposed by the necessity of large-scale dynamic hedging inherent in a large swaps market. We fear the dollar and interest rate markets are prone to derivative-related trend-following trading dynamics and potential dislocation.

So we are left today pondering the "Bundling" of Credit, dollar, and interest rate risk in the swaps market and the increasing impairment of the major derivative players. And with acute dollar weakness, what appears a "meltup" dislocation in the Treasury and agency markets, collapsing swap spreads, and faltering stock prices for the major derivative players such as JPMorgan, Citibank, Goldman Sachs, Morgan Stanley and Merrill Lynch, we do tend to see support for our view of unfolding derivative problems. Unlike the 1998 dislocation that erupted from the reckless leveraging of LTCM and others, the unfolding 2002 crisis involves structural market distortions in risk and risk mitigation. By its very nature, this crisis will not be easily resolved.

The basic problem is that years of unprecedented Credit and speculative excess have created unfathomable and growing market risk throughout the U.S. financial system - Credit risk, risk to changing interest rates, and the extreme dollar risk associated with an unprecedented exponential rise in dollar claims. It is our view that unrelenting Credit excess and the corresponding growth in the global swaps market have now transformed the nature of U.S. risk to one of an acute systemic nature. It involves our markets, our major financial institutions, and our distorted economy. And when it comes to systemic risk, as we have explained in the past, when the "market" wishes to hedge, there is no one with the wherewithal to take the other side of the trade. The thinly capitalized and thickly market-exposed derivative players certainly have little equity cushion to provide "insurance" protection. Nor is it possible to "hedge" systemic risk in the derivative or swaps market if there is a general move away from dollar assets. At some point, the only way to mitigate risk is to liquidate U.S. financial assets.

At the same time, the system requires unrelenting Credit excess to sustain the U.S. economic Bubble and maintain inflated asset markets. This has been the case for some time, but it has recently become a much more serious issue. Rampant domestic Credit excess is today problematic in at least two major ways. First, it fosters larger trade deficits and excess dollar balances globally in an environment of heightened aversion to dollars. Second, it exacerbates the accumulation of additional dangerous risk in the hands of increasingly impaired U.S. financial institutions and speculators. We are to the point where we believe the mortgage finance Bubble is a dollar problem. The Fed is now faced with significant risk if it moved to control this Bubble. Foreign players have good reason to presume that the Fed, GSEs and U.S. financial sector will instead go to great extremes to ensure the mortgage finance Bubble does not burst. Therefore, foreign holders of dollar assets must clearly fear continued uncontrolled non-productive Credit excess - the continuing inflation of dollar financial claims. The U.S. system's unfettered capacity for creating it's own liquidity will now be the dollar's Achilles heel.

So we are left today increasingly convinced we are approaching a dislocation in the risk market and this risk is today manifesting in the currency markets. What exactly this means is not at all clear. But we are convinced of a few things. The unprecedented creation of dollar claims over the past several years puts the dollar at the epicenter of any unfolding dislocation. We also believe dollar risk is compounded by the fact that major U.S. financial institutions are the core of an acutely vulnerable global derivatives market. And we also believe that unabated rampant U.S. Credit excess - especially of the nature of a mortgage finance Bubble - will only exacerbate unfolding dollar, derivative, and U.S. financial institution problems. The U.S. financial sector may have mastered uninterrupted Credit excess, but this now only ensures an inevitable financial crisis.

But how a dollar problem and derivative dislocation manifests in the U.S. stock and Credit market is a difficult call to make today. Could a faltering dollar lead to a major foreign liquidation of U.S. equity holdings, and could this prove the catalyst for financial dislocation? Or is a major stock dislocation likely held at bay until the unfolding dislocation impinges systemic liquidity? There is also the key issue of whether we will see market forces develop that will finally work to temper domestic Credit excess. At the minimum, we have entered an environment of heightened risk aversion. This will once again surely force the GSEs and U.S. financial sector to acquire risky assets while issuing "safe" monetary liabilities. While we have seen this process function splendidly several times before, we see a major problem this time around. The Fed has fired its bullets, the dollar is under pressure, and a conspicuous mortgage finance Bubble runs out of control. The system is running near the end of its rope. We see today little possibility for a positive market reaction to one more round of "reliquefication." What this means going forward is that those institutions that issue "money" and acquire risk will be stuck holding increasingly problematic risk in an especially inhospitable environment.

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