Is it a bear or the beginning of wild volatility... For the week, the Dow declined 2.0%, and the S&P500 fell 1.9%. Economically sensitive issues were under pressure, with the Transports down 4.4% and the Morgan Stanley Cyclical index falling 3.3%. Defensive issues outperformed. The Utilities dipped 0.6%, and the Morgan Stanley Consumer index declined 0.8%. The small cap Russell 2000 dropped 2.7%, and the S&P400 Mid-cap index fell 3.3%. The NASDAQ100 declined 2.0%, and the Morgan Stanley High Tech index dropped 2.6%. The Semiconductors dipped 0.4%. The Street.com Internet Index sank 3.5%, and the NASDAQ Telecommunications index declined 1.6%. The Biotechs were hit for 3.6%. The broker/dealers fell 3%, and the Banks declined 1.6%. With bullion sinking $55.40, the HUI gold index dropped 12.8%.

For the week, two-year Treasury yields declined 4 bps to 4.96%, and five-year yields sank 12 bps to 4.96%. Bellwether 10-year yields fell 14 bps to 5.06%. Long-bond yields sank 17 bps to 5.14%. The 2yr/10yr spread narrowed a notable 10 bps, ending the week at a positive 8 bps. Benchmark Fannie Mae MBS yields declined 5 bps to 6.21%, this week underperforming Treasuries. The spread on Fannie's 4 5/8% 2014 note ended the week little changed at 25, and the spread on Freddie's 5% 2014 note was unchanged at 27. The 10-year dollar swap spread increased 1.5 to 53.75. Corporate bond spreads widened somewhat this week, with junk lagging. The implied yield on 3-month December '06 Eurodollars added one basis point to 5.37%.

It was another big week of corporate debt issuance. Investment grade issuers included AT&T $1.5 billion, Washington Mutual $1.25 billion, BAC Capital Trust $1.0 billion, Sun Life Financial $900 million, International Lease Finance $500 million, Monumental Global $500 million, American Express $400 million, Northern State Power $400 million, Agrium $300 million, Great West Life $300 million, Pricoa Global Funding $300 million, and Detroit Edison $250 million.

Junk issuers included Edison Mission Energy $1.0 billion, Reynolds American $625 million, Centerpoint Energy $325 million, PPL Energy Supply $300 million, Sesi LLC $300 million, American Greetings $200 million, Unifi $190 million, and Range Resources $150 million.

Convert issuers included Neighbors Industries $2.5 billion, Education Management $760 million, Enzon $400 million, FEI Company $115 million, and Greenbrier Companies $85 million.

Foreign dollar debt issuers included European Investment Bank $3.0 billion, Qatar Petroleum $650 million, and Korea South-East Power $300 million.

May 16 - Dow Jones (Christine Richard): "The $500 billion deficit in U.S. company retirement plans is about to bite corporate bond investors. Goodyear Tire & Rubber Co., Eastman Kodak Co., TRW Automotive Holdings Corp. and hundreds more companies delinquent in contributing to pensions will have to disclose more information about retirement funds and health-care costs in financial statements later this year, accounting rulemakers say. Congress is debating a new law that would force them to start plugging the gaps in their pension plans."

May 17 - Financial Times (Paul J Davies and Louisa Mitchell): "Global corporate bond markets saw one of the heaviest weeks for new issuance of all time last week in spite of increasing uncertainty over the outlook for broader markets and the world's economies. Bankers disagree on whether it was the biggest week ever, or just one of the largest, but figures from Dealogic put global investment grade corporate issuance, excluding financial groups, at $28.5bn, making the fifth-biggest week since it began measuring the data in 1992. Adding in junk bond issues takes that figure to $33.3bn globally. This week is also expected to be busy..."

Japanese 10-year JGB yields dropped 8 bps this week to 1.905%. The Nikkei 225 index declined 2.7% (up 0.3% y-t-d). German 10-year bund yields fell 10 bps to 3.98%. Emerging markets were under pressure. Brazil's benchmark dollar bond yields jumped 11 bps to 7.19%. Brazil's Bovespa equity index was hit for 6.2%, reducing 2006 gains to 12.8%. The Mexican Bolsa fell 4.6% (up 13.4% y-t-d), while Mexico's 10-year $ yields added 3 bps to 6.27%. Russian 10-year dollar Eurobond yields dipped one basis point to 6.84%. The Russian RTS equities index was hammered for 13.8%, lowering 2006 gains to 28.8% and 52-week gains to 124%. India's Sensex equities index sank 11% (up 16% y-t-d).

Freddie Mac posted 30-year fixed mortgage rates added 2 bps to 6.60%, up 89 basis points from one year ago. Fifteen-year fixed mortgage rates rose 3 bps to 6.1%, 93 bps higher than a year ago. One-year adjustable rates were unchanged at 5.62%, an increase of 136 bps over the past year. The Mortgage Bankers Association Purchase Applications Index gained 2.4% last week. Purchase Applications were down 8.6% from one year ago, with dollar volume down 4.1%. Refi applications gained 8.4% last week. The average new Purchase mortgage jumped to $238,000, while the average ARM was little changed at $346,700.

Bank Credit surged another $43.3 billion last week to a record $7.890 Trillion, with a y-t-d gain of $384 billion, or 14.0% annualized. Over the past year, Bank Credit inflated $803 billion, or 11.3%. For the week, Securities Credit rose $8.6 billion. Loans & Leases jumped $34.7 billion for the week, with a y-t-d gain of $121 billion (11.0% annualized). Commercial & Industrial (C&I) Loans have expanded at a 16.5% rate y-t-d and 14.5% over the past year. For the week, C&I loans were unchanged, while Real Estate loans rose $9.4 billion. Real Estate loans have expanded at a 10.5% rate y-t-d and were up 12.8% during the past 52 weeks. For the week, Consumer loans added $1.2 billion, and Securities loans increased $16.9 billion. Other loans were up $7.3 billion. On the liability side, (previous M3 component) Large Time Deposits gained $1.6 billion.

M2 (narrow) "money" supply dropped $23.9 billion to $6.770 Trillion (week of May 8). Year-to-date, narrow "money" has expanded $81.2 billion, or 3.3% annualized. Over 52 weeks, M2 has inflated $286 billion, or 4.4%. For the week, Currency added $0.4 billion. Demand & Checkable Deposits declined $5.8 billion. Savings Deposits sank $21.2 billion, while Small Denominated Deposits added $3.1 billion. Retail Money Fund assets dipped $0.2 billion.

Total Money Market Fund Assets, as reported by the Investment Company Institute, jumped $13.4 billion last week to $2.058 Trillion. Money Fund Assets are about unchanged y-t-d, with a one-year gain of $171 billion (9.1%).

Total Commercial Paper jumped $8.1 billion last week to $1.767 Trillion. Total CP is up $118 billion y-t-d, or 18.6% annualized, while having expanded $253 billion over the past 52 weeks, or 16.6%.

Asset-backed Securities (ABS) issuance increased this week to $17 billion. Year-to-date total ABS issuance of $261 billion (tallied by JPMorgan) is running slightly ahead of 2005's record pace, with y-t-d Home Equity Loan ABS sales of $184 billion 10% above last year.

Fed Foreign Holdings of Treasury, Agency Debt ("US marketable securities held by the NY Fed in custody for foreign official and international accounts") increased $3.4 billion to $1.624 Trillion for the week ended May 17th. "Custody" holdings are up $105 billion y-t-d, or 18.0% annualized, and $220 billion (15.7%) over the past 52 weeks. Federal Reserve Credit was about unchanged at $825 billion. Fed Credit has declined $1.7 billion y-t-d, or 0.5% annualized. Fed Credit expanded 4.7% ($37bn) during the past year.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - are up $338 billion y-t-d (22% annualized) and $534 billion (13.9%) in the past year to $4.385 Trillion.

Currency Watch:

The dollar index rallied 1.1% this week. On the upside, the Peruvian new sol gained 0.4% and the Mauritius rupee 0.3%. On the downside, the Indonesian rupiah fell 4.7%, the Turkish lira 3.8%, the Colombian peso 3.1%, the South African rand 2.9%, and the Brazilian real 2.8%. The Swiss franc declined 1.5% and the Euro fell 1.1%.

Commodities Watch:

May 17 - Bloomberg (Jeb Blount): "Cia. Vale do Rio Doce, the world's largest iron-ore producer, said Japanese steelmakers agreed to a 19 percent increase in the price of iron-ore for 2006."

May 17 - Bloomberg (Jeff Wilson): "U.S. wheat prices surged more than 4 percent to nine-year highs on speculation a return to hot, dry weather will damage crops from Kansas to Montana. Temperatures across the Great Plains will reach 95 degrees Fahrenheit tomorrow and stay as much as 10 degrees above normal in the next four weeks..."

It was a little volatile in the commodities markets... For the week, Gold dropped 7.8% to $659, and Silver fell 13% to $12.36. Copper sank 10%. June crude declined $3.51 to $68.53. June Unleaded Gasoline fell 6.4%, and June Natural Gas dropped 5.1%. For the week, the CRB index sank 6.4% (y-t-d up 2.1%). The Goldman Sachs Commodities Index (GSCI) dropped 5.5%, reducing y-t-d gains to 7.7%.

Japan Watch:

May 15 - Bloomberg (Jason Clenfield and Lily Nonomiya): "Japan's current account surplus widened to a record as companies brought home profit from abroad and overseas demand for cars and electronics lifted exports. The surplus rose 33 percent to 2.39 trillion yen ($21.8 billion) from a year earlier..."

May 16 - Bloomberg (Lily Nonomiya): "Japan's households became confident for the first time in more than 15 years in April as wages rise and job prospects improve. Consumer confidence among households with two or more people rose to 50 from 47.9 in March, the Cabinet Office said..."

China Watch:

May 15 - Bloomberg (Jianguo Jiang): "China's banks doubled their new yuan lending in April compared with last year to about 310 billion yuan ($38.7 billion), China Business News said, citing unidentified officials."

May 18 - Bloomberg (Nerys Avery): "Investment in China's real estate, factories and railways rose at close to the fastest pace since September 2004 in the first four months, adding to expectations that the government may take more measures to curb expansion. Fixed-asset investment in towns and cities climbed 29.6 percent to 1.8 trillion yuan ($224 billion) through April..."

May 17 - Bloomberg (Nerys Avery): "China's industrial production rose 16.6 percent in April as factories churned out more cars, mobile phones and steel to meet rising demand at home and abroad."

May 16 - Bloomberg (Luo Jun): "China's securities regulator will allow fund management companies to invest in asset-backed securities to expand their investment scope and boost returns. Starting today, fund managers can invest up to a combined 20 percent of their net assets..."

May 18 - Bloomberg (Nipa Piboontanasawat): "Hong Kong's unemployment rate fell to the lowest in almost five years in April as the economy improved and companies hired more workers to expand. The seasonally adjusted jobless rate declined to 5.1 percent..."

Asia Boom Watch:

May 18 - Bloomberg (Theresa Tang and James Peng): "Taiwan's economy grew at a slower pace in the first quarter as rising credit-card debt and higher fuel prices damped consumer spending. Gross domestic product rose 4.93 percent from a year earlier after climbing 6.4 percent in the fourth quarter..."

May 17 - Bloomberg (Shamim Adam): "Singapore's government raised its 2006 economic growth forecast to as much as 7 percent, joining South Korea and Taiwan in predicting faster expansion because of a jump in global consumer electronics demand."

May 17 - Bloomberg (Chan Tien Hin): "Malaysia's inflation rate held near a seven-year high in April as rising fuel prices increased transportation costs. The consumer price index rose 4.6 percent from a year..."

Unbalanced Global Economy Watch:

May 18 - CNW: "The cost of owning a home in Alberta continued to increase as rising house prices and mortgage rates outpaced strong income and employment growth for the second consecutive quarter... 'The good times for the Alberta economy have come at a cost to homebuyers as the housing market has witnessed year-over-year price growth of about 25 per cent in all classes of homes,' said Derek Holt, assistant chief economist, RBC. 'In just one quarter alone, two-storey homeowners realized an average $28,000 price gain.'"

May 19 - Bloomberg (Greg Quinn): "Canada's retail sales rose 1.5 percent in March to a record, with a rebound at new car and truck dealers leading the biggest gain in eight months."

May 16 - Bloomberg (Simone Meier and Sandrine Rastello): "European Central Bank council member Christian Noyer said borrowing costs are 'extremely favorable' and oil prices are likely to stay high, suggesting he would support raising interest rates as early as next month."

May 18 - Bloomberg (Simone Meier): "The economic climate in the dozen nations sharing the euro is the best in five years, Germany's Ifo economic institute said..."

May 17 - Bloomberg (Craig Stirling): "U.K. jobless claims rose in April to the highest in almost three years after manufacturers shed jobs to weather an economic slowdown last year and surging oil costs."

May 19 - Bloomberg (Jacob Greber): "Swiss producer and import prices rose the most in 13 years in April as surging oil costs pushed up the price of energy. An index measuring prices for factory and farm goods as well as imports rose 0.8 percent from the previous month..."

May 16 - Bloomberg (Evalinde Eelens): "Dutch exports and imports rose to records in March, helped by an increase in volume and prices. Exports rose 18 percent to 28.5 billion euros ($36.5 billion), from a year earlier, while imports climbed 18 percent to 24.8 billion euros..."

May 17 - Bloomberg (Svenja O'Donnell): "Russian industrial production rose 4.8 percent in April, more than expected, as output of construction materials and coal increased."

May 19 - Bloomberg (Hannah Gardner): "Russia's economy attracted $8.78 billion in investments in the first quarter, 46 percent more than in the same period a year earlier."

May 16 - Bloomberg (Vernon Wessels): "Africa's economic growth will accelerate to 5.8 percent this year from 5 percent last year, led by oil producing nations such as Nigeria and Angola, according to the Organization for Economic Cooperation and Development... 'The outlook for much of Africa continues to be more favorable than it has been for many years,' the OECD said..."

May 16 - Bloomberg (Jason Gale): "Last month, a year-old racehorse was sold in Sydney for A$3 million ($2.2 million), a beachfront home near Melbourne went for A$8.6 million and Sotheby's auctioned an Australian painting for A$3.1 million. All are records. The buying power of Australia's new millionaires is being felt from stores selling A$1,200 Manolo Blahnik pumps to car dealerships pushing A$400,000 Lamborghinis. Private sector wealth grew 12 percent in the year ended June 30..."

May 18 - Bloomberg (Gemma Daley): "Australian consumers expect prices will rise 4.9 percent in the next 12 months, according to a survey of households.... That's higher than the 4.8 percent expectation in April."

Latin America Watch:

May 17 - Bloomberg (Patrick Harrington): "Mexico's economy expanded at its fastest pace in almost six years in the first quarter, spurred by record oil prices, falling interest rates and growing U.S. demand for exports. The economy grew 5.5 percent from the year-earlier period after expanding 2.7 percent in the fourth quarter..."

May 15 - Bloomberg (Patrick Harrington): "Mexico's industrial production rose at the fastest pace in eight years in March as quickening U.S. growth bolstered automobile exports and falling interest rates spurred demand for new homes and appliances. Output rose 9.7 percent in the month from the year-earlier..."

May 15 - Bloomberg (Alex Emery): "Peru's economy grew at the fastest pace in nine years in March on surging production of copper, gold and fishmeal. Gross domestic product expanded 10.7 percent in March..."

May 18 - Bloomberg (Alex Kennedy): "Venezuelan retail sales rose by at least 30 percent for a fifth month in February as increased government spending spurred consumer demand."

Central Bank Watch:

May 19 - Bloomberg (Jonas Bergman): "Sweden's central bank said it 'routinely' considers asset prices and incorporates economic measures such as growth and unemployment when setting monetary policy in the largest Nordic economy. 'The Riksbank routinely takes into consideration changes in asset prices and other financial variables' such as exchange rates, house prices, share prices, household and corporate debt, the Stockholm-based bank said today in a report that it said replaces a clarification of policy from 1999. It has 'scope' to consider both inflation and the 'real economy.'"

Bubble Economy Watch:

May 17 - Bloomberg (Jack Kaskey): "DuPont Co., the third-biggest U.S. chemical maker, said it will raise prices on most products for the second time in less than a year as it struggles to recoup higher costs for raw materials derived from oil and natural gas."

May 16 - MarketNewsInt.(Claudia Hirsch): "U.S. healthcare service providers said higher input costs, soggy insurance reimbursement rates and stagnant patient fees are squeezing their profits. Healthcare professionals said fuel, rent and labor outlays are trending higher. But fees for medical services remain steady, held in check by steady-to-softer reimbursement rates, they said. Insurers reported that prices for physician and outpatient services are rising fastest, while group premium increases are slowing."

May 18 - Dow Jones: "A report [from] the Federal Energy Regulatory Commission indicated that parts of California - particularly in the southern part of the state - as well as New York, Connecticut and Ontario, Canada, could face electricity shortages when demand peaks this summer."

Real Estate Bubble Watch:

May 18 - Bloomberg (Daniel Taub): "San Francisco Bay Area home sales fell 25.1 percent last month, the steepest drop in more than four years, as rising interest rates discouraged buying, according to...DataQuick... The median price in the Bay Area was $628,000 last month, up 7.2 percent from a year earlier, the smallest year-over-year increase since August 2003... Last month's median price was a record. In Southern California, home prices last month rose less than 10 percent for the first time since November 2001 as sales declined 21.3 percent from a year earlier..."

May 16 - Florida Association of Realtors: "In first quarter 2006, Florida's housing sector followed the national trend, demonstrating signs of a market adjusting to rising mortgage rates and higher inventory levels... Statewide sales of single-family existing homes totaled 45,864 during the three-month period, a decrease of 20 percent compared to 57,532 homes sold during the same quarter a year ago... The statewide existing-home median sales price rose 20 percent to reach $248,000...a year ago, it was $206,700. In 2001, the first-quarter statewide median sales price was $119,500..."

Financial Sphere Bubble Watch:

May 17 - Financial Times (Paul J Davies, Louisa Mitchell and Gillian Tett ): "A boom in merger and acquisition activity and a rush to lock in cheap finance ahead of likely interest rate rises later this year is leading companies to raise capital at a faster pace than ever before. The past 10 days have seen record levels of US and European corporate bond issuance, according to bank syndication teams. At the same time companies are turning to the equity markets where, in the US, the pace of filings for initial public offerings has reached its fastest since the technology boom six years ago. Last Friday was the busiest single day for filings with the Securities and Exchange Commission since March 2000, with 11 companies filing for IPOs, according to Dealogic, the data provider. On the bond markets, Barclays Capital estimates about €8bn ($10bn) in big euro-denominated corporate issues were sold last week, while £2bn ($3.8bn) of sterling-denominated deals and another $30bn in dollar deals were placed around the world - a weekly record."

Mortgage Finance and Real Estate Bubble Watch:

May 17 - The Wall Street Journal (Ryan Chittum): "As the retail real-estate industry prepares for its big annual show - the International Council of Shopping Centers convention in Las Vegas next week -- one question is increasingly being asked in the business: How long will the strong sales and easy money last? The shopping-center industry outlook remains solid, lenders are funding deals at record prices and retailers are looking to expand, while new construction remains restrained. But retail real estate and the economy at large have been buoyed over the last several years by consumer spending, thanks to record run-ups in home prices and the home-equity loans used by owners to keep spending."

Energy and Crude Liquidity Watch:

May 16 - Financial Times (William Wallis): "Moody's, the ratings agency, has warned of a build-up of systemic risk in banks operating in the Gulf as a result of rapid loan growth and 'possible asset bubbles.' A report by Moody's to be released today says the financial performance of Gulf banks has improved in recent years - and now compares favourably with those of higher-rated institutions in other parts of the world - thanks to booming economies underpinned by soaring world prices for oil and gas. In most cases this has made for a stable medium-term outlook."

May 16 - Bloomberg (Dania Saadi): "Saudi Arabia's King Abdullah wants to create a fund to allow low-income earners to invest in the country's stock exchange, which has lost almost half its value since peaking on Feb. 25. 'If the low-income earner gains, then it's his luck,' King Abdullah said...'If he loses, then his capital will remain intact.'"

May 17 - Bloomberg (Marc Wolfensberger): "Iran's oil revenue will rise 23 percent to $55 billion this year as international oil prices surge, said Hadi Nejad-Hosseinian, Iran's deputy oil minister for international affairs."

Speculator Watch:

May 16 - Financial Times (John Dizard): "'You're going to find out your biggest problem is not bringing in the stuff but what to do with all the . . . cash' - Frank Lopez (Robert Loggia), Scarface (1983). Private equity firm principals have a problem similar to the one that burdened Scarface's drug kingpin. They can also bring in the 'stuff', by successfully floating limited partnerships. But what are they going to do with all the cash? There are a couple of hundred billion dollars burning a hole in the pockets of the private equity firms. I have heard from many people that there have been several recent attempts at floating $10bn plus IPOs."

The Evolving Nature of the Financial System: Financial Crises and the Role of the Central Bank:

May 19 - Bloomberg (Hamish Risk): "The global derivatives market expanded to a record $298 trillion in the second half of 2005, led by a 34 percent increase in contracts to insure debt payments, the Bank for International Settlements said... Credit-default swaps rose to $13.7 trillion..."

May 19 - Financial Times (Gillian Tett ): "The recent sharp falls in stock markets appear to have been exacerbated by an unusual wave of derivatives activity on the part of hedge funds and big banks, traders yesterday indicated. In particular, some banks and big investors appear to have been forced into selling large amounts of equity futures because they have been acting as counter-parties to large, leveraged bets on the direction of stock market volatility in recent months - and these bets are now unravelling because volatility has increased sharply. This forced selling has hurt equity futures index prices on markets such as the London International Futures Exchange - and depressed the value of cash equities as well, some observers suggest. 'This is an incredibly sensitive topic but it looks as if some big investors are being forced into big moves because they need to hedge these [derivatives] positions,' one senior trader said yesterday. It is impossible to track this type of derivatives trading with accuracy, since the investors and banks engaged in these markets are extremely anxious to keep their positions private."

May 19 - Bloomberg (Kevin Carmichael and Carlos Torres): "Former Federal Reserve Chairman Alan Greenspan comments on the regulation of hedge funds, market efficiency and productivity... Greenspan said he opposed stronger regulations for hedge funds because that would hinder their ability to do what they do well -- make the financial system more efficient. Hedge funds all are looking for profits above the average rate of return, he said. Hedge funds find those returns because of 'market inefficiency.' Therefore, hedge funds 'increase the efficiency of the financial system.' That's part of the reason the U.S. has been able to boost productivity rates even with low savings rates, he said. 'We use our savings in a very effective way.'"

Thursday evening (at The Conference on New Directions for Understanding Systemic Risk) Fed Governor (and new Vice-Chairman) Donald Kohn, gave an interesting talk, "The Evolving Nature of the Financial System: Financial Crises and the Role of the Central Bank." Considering the environment, Mr. Kohn's comments are worthy of highlighting and discussing:

Dr. Kohn: "Maintaining the stability of the financial system and containing the systemic risk that may arise in financial markets has been central to the Federal Reserve's mission for as long as there has been a Federal Reserve. Indeed, Congress passed the Federal Reserve Act in 1913 to provide the nation with a safer and more stable monetary and financial system... At the beginning of the twentieth century, banks were virtually the only financial intermediary available. Periodically, these highly leveraged institutions lost the confidence of depositors, fell into crisis, and reduced their lending to creditworthy borrowers, thereby accentuating economic downturns. The tools that were developed to prevent and to manage financial crises--lender-of-last-resort facilities, supervision and regulation aimed at bank safety and soundness, deposit insurance, and the provision of payment system services--were geared toward a bank-denominated system."

"Today, multiple avenues of financial intermediation are available, and the financial system has become much more market-dominated. This evolution of financial institutions and markets probably has made the financial system more resilient. Financial innovations, such as the development of derivatives markets and the securitization of assets, have enabled intermediaries to diversify and manage risk better. Moreover, as markets have become more important, ultimate borrowers have acquired more avenues to tailor their risk profiles and are less dependent on particular lenders, and savers have become better able to diversify and to manage their portfolios. Consequently, the economy has become less vulnerable to problems at individual types of institutions."

My comment: As expected, the Bernanke Fed is content to follow the Greenspan ideology that derivatives, hedge funds and "contemporary finance," generally, are highly beneficial to financial and economic system stability. The focal point of the Fed's rationalization is the capacity for today's systems to isolate, disperse and mitigate risk. There is, however, no denying the prominent role derivatives and the leveraged speculation play in promoting Credit availability and system leveraging. As always, it is the innate nature of "highly leveraged institutions" to create fragility and the risk of crisis. A very strong case can be made that the U.S. economy is today extraordinarily vulnerable to any interruption in system Credit creation or marketplace disruption.

Dr. Kohn: "The 1987 stock market crash may have been the first modern financial crisis in the United States. Unlike previous financial crises, the 1987 stock market decline was not associated with a deposit run or any other problem in the banking sector. Instead, the 20 percent decline on October 19, 1987... was driven by investor decisions to reduce equity exposures and by the resulting chaotic trading in the stock markets..."

"The liquidity crisis in the fall of 1998 was triggered by the Russian debt default in August and then aggravated by the problems at the hedge fund Long-Term Capital Management. During the 1998 crisis, risk spreads widened sharply, stock prices fell, and liquidity became so highly valued that the spread between on- and off-the-run Treasury securities widened substantially. Of even more concern, the capital markets virtually seized up as market participants retreated from risk taking, and, for a time, credit was simply unavailable to many private borrowers at any price."

"The events of 1987 and 1998 had several common elements. First, they began with sharp movements in asset prices. Second, these price movements were exacerbated by market participants trying to protect themselves--with portfolio insurance in 1987 and by closing out positions in 1998. Third, market participants became highly uncertain about the dynamics of the market, the "true" value of assets, and the future movement of asset prices. As a consequence, with their standard risk-management systems seemingly inapplicable, they pulled back from making markets and taking positions and further exacerbated the price action. Fourth, the large and rapid price movements called into doubt the creditworthiness of counterparties, which could no longer be judged by now obsolete financial statements; credit decisions were further complicated by uncertainty about the value of collateral. In turn, the defensive behavior of market participants escalated and reinforced adverse market dynamics. Finally, the decline in asset prices reduced wealth and raised the cost of capital, which seemed likely to reduce both consumption and investment."

My comment: It is definitely well-timed for the Fed to refresh their analyses of the '87 and '98 financial market dislocations. Unfortunately, the Fed's view of both episodes offers Important Lessons Not Learned. The 1987 stock market crash was precipitated by a confluence of highly speculative trading, along with the aggressive use of a new market hedging vehicle - "portfolio insurance." Importantly, the dynamic-trading nature of the hedging strategy - that writers of the market insurance were to sell S&P futures contracts into a declining market to establish short positions that would generate the positive cash flow to make payment on the contract - led to precipitous and self-reinforcing selling in the futures market. "Computer-generated" sell programs culminated in marketplace dislocation and collapse.

Immediately after the crash, there were fears that the markets were discounting a severe economic downturn (even depression), although this financial crisis was largely contained to the equities markets. Importantly, uncertainty and tumult were only somewhat of a setback for the Credit system. It was, however, not long before Fed liquidity injections and sharply lower market rates bolstered a Credit apparatus that was already well on its way to financing a boom. Late-eighties excesses, including the junk bond, LBO, coastal real estate, and national commercial real estate booms, may seem rather picayune these days, but virtually pushed the banking system over the edge by the early nineties.

From the 1987 stock market crash, the Fed understood that it may very well be necessary to intervene in the marketplace to cushion the influence of some of the new financial "innovations." This certainly included interventions to forestall marketplace bouts of trend-following derivative-related selling and other forced liquidations. This policy insight served them well during the LTCM crisis. When the disintegration of a highly leveraged portfolio of international bond bets risked precipitating a global financial market dislocation, Greenspan hastily intervened. The Fed shielded the insolvent LTCM from liquidation, aggressively cut rates, added liquidity and, importantly, assured the markets that the U.S. government - the Greenspan, Rubin and Summers "Committee to Save the World" -- were ready and willing to employ unprecedented measures to guarantee liquid and continuous markets. I have in the past written extensively regarding the momentous moral hazard implications of this endeavor and will not delve further into this issue this evening.

With regard to policy implications, the Greenspan Fed emerged from the LTCM crisis resolution with an intrepid appreciation for the unparalleled power and control they now exercised over marketplace liquidity. Virtually on demand, Greenspan could incite risk-taking and leveraged speculation, both activities that would immediately add to marketplace liquidity, stimulate borrowing and risk-taking, boost asset prices, and only somewhat later stimulate economic activity.

The instantaneous actions of today's leveraged speculators can be compared to the influence adding reserves and tinkering with interest-rates - the Fed's old toolkit - previously had nudging along bank loan officers and businesspersons. I have always believed that the primary impetus for Greenspan's championing of derivatives, hedge funds and Wall Street finance was that they afforded him the most powerful policy device in the history of central banking. Besides, in post-LTCM analysis, the Fed could rationalize their intervention with the notion that their encroachment stemmed the forced liquidation of high-quality debt instruments held by Credit-worthy borrowers.

The next major financial crisis will be of much broader scope than 1998, just as LTCM was to 1987. I believe the probability for such a crisis during the next year is high, and I wouldn't be surprised if recent market turbulence is a precursor of trouble ahead. With this in mind, I will briefly share some thoughts I have as to why the next crisis will be significantly more problematic for the Fed.

First of all, I cannot write enough times that the key to the so-called "resiliency" of the U.S. markets and economy has been due to the capacity for uninterrupted Credit growth and marketplace liquidity creation. While there have been a few instances where the flow of new finance was at risk, in each case the Credit wheels were greased with lower rates and assurances of a hospitable environment for risk-taking. The Fed enjoyed great flexibility during the LTCM crisis. The global backdrop (post-Mexico, SE Asia and Russian collapses) was quite disinflationary, especially in the energy and commodities markets. Oil was heading to $10, gold to $250, and the CRB index to multi-decade lows. And, importantly, while the dollar did weaken around the time of the worst of the LTCM scare, it had rallied 25% over the preceding three-year period (on its way to King Dollar highs). The Fed enjoyed the incredible luxury of inciting massive Credit inflation with confidence that dollar liquidity would readily find a home in U.S. securities markets (where the nature of its inflationary impact was largely contained).

The genesis of the problem for the market during 1998 was one of illiquidity and the forced unwind of various Credit spreads, derivatives, and interest-rate arbitrages. The potential collapse and liquidation of LTCM (and copycats) was hanging over the marketplace; players were either hastily liquidating positions or completely backing away from the market in anticipation of a marketplace dislocation. But this predicament was certainly amenable to lower rates, additional liquidity, and concerted Fed and Treasury assurances that a marketplace disruption would be avoided at all costs.

The next financial crisis will be much less agreeable. For one, I believe the general nature of leveraged speculating is different today. The type of the underlying assets being financed (distorted and inflating global assets) is altogether different, and the general inflationary/liquidity backdrop is unrecognizable from 1998. Whereas in LTCM speculations were primarily Credit spreads and various rate-arbitrages, I fear the prominent trades today are more of the global carry trade variety. These involve borrowing in low-yielding currencies to finance speculations in instruments of higher-yielding currencies. This recalls SE Asia, Russia and Argentina.

Objectively surveying the global environment, one can surmise that today's leveraged speculations are financing gross and unsustainable distortions (including U.S. over-consumption and global asset inflation). This implies especially weak underlying Credit instrument fundamentals, basically a non-issue back in 1998. To what degree leveraged speculations have been financing our Current Account Deficit is unknown, but this could prove to be a huge issue in the event of a currency market disruption. One can envisage a scenario where the Fed's best intention of supporting the marketplace in providing Credit to "worthy borrowers," is undermined by the deteriorating view of U.S. creditworthiness. There is a huge risk associated with financing serial current account deficits and asset inflation with market-based leveraged speculations. To be sure, U.S. imbalances and policymaking are certainly held in much less regard these days.

I will suggest this evening that acute dollar vulnerability is poised to significantly curtail the Bernanke Fed's flexibility. The ramifications for a policy approach that pushes the Credit system into overdrive to counter financial disruption are different going forward - perhaps much different. The greatest problem for the global financial system currently is enormous and relentless dollar liquidity excess. Inciting Credit growth and risk-taking may very well prove counter-productive, and it is likely that aggressive (1998-style) Fed actions would only exacerbate a flight out of dollar securities. A flight from the dollar would only worsen the deteriorating inflation backdrop. Not only is it possible that the Fed loses the luxury of lowering rates during the next crisis, it may very well be forced at some point to do what other countries do and raise rates to mitigate a run on its currency.

Perhaps we've already been somewhat privy to the backdrop for the next crisis: a sinking dollar, spiking metals prices, surging crude, and rising global bond yields. A scenario where marketplace dislocation manifests first in the currency markets (with a faltering dollar) is as reasonable as it would be problematic. Here, one would assume that the Fed's proven modus operandi of adding liquidity, cutting rates, and inciting more Credit and liquidity would be only counter-productive. And, as we have witnessed, the nature and consequence of current leveraged speculation are more unsettling than those preceding 1998. Today's inflationary backdrop nurtures destabilizing speculative leveraging in all the "un-dollar" markets - certainly including the emerging markets and commodities. This creates a highly unstable situation prone to myriad and recurring Bubbles, volatility and busts. Accordingly, the characteristics of the underlying debt instruments are problematic, and increasingly susceptible to wild price gyrations.

I read a lot about Bubbles these days: The "energy Bubble", the "metals Bubble", the "commodities Bubble", the "emerging market Bubble", the "hedge fund Bubble", and so on. But most of the analysis misses the most salient points. What we're dealing with - the overriding issue is - The Dollar Liquidity Bubble. The combination of massive Current Account Deficits and outbound (investor and speculator) finance is inundating the financial world, and there is no way short of a major U.S. crisis to rein it in. This liquidity is fueling myriad dramatic global marketplace price inflations - as well as the occasional hiccup - along the way. I don't view recent pull-backs in these markets as bursting Bubbles because I don't yet see any change to the nature of underlying dollar liquidity excess.

In conclusion:

May 19 - Dow Jones: "Former Federal Reserve Chairman Alan Greenspan said Thursday that the U.S. is 'fortunate' in being able to run large current account deficits, a result of increasingly globalized economies and capital markets. Greenspan said that there has been a 'large dispersion' of current account deficits and surpluses across the global economy as developing nations with higher savings rates have begun to catch up economically with their developed-world counterparts. This has created a flow of savings from these developing countries which has allowed the U.S. to comfortably finance the 'large deficits' that it has run in recent years."