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Following in Dr. Fisher's Footsteps

It was another positive week for stocks. Strong performance by Merck, Microsoft and GM offset Kodak's decline and helped move the Dow almost 1% higher on the week. The S&P500 added another 0.7% this week, increasing its year-to-date gain to 13.2%. The Transports dipped 0.5% while the Utilities performed well, adding 2.4%. The Morgan Stanley Cyclical index added 1.5% and the Consumer index gained 0.6%. The broader market was relatively quiet, with the small-cap Russell 2000 flat for the week. The S&P400 Midcap index added 0.4%. The highflying technology sector pushed the NASDAQ100 gain 1.6% higher (up 24% y-t-d). The Morgan Stanley High Tech index rose 3%, while the Semiconductors recovered almost 3% after last week's 7% decline. The Internet stock frenzy continues, with The Street.com Internet Index adding 3.1%. This brings its 2003 gain to 43%. The NASDAQ Telecom Index added 1.5%. The speculative Biotechs finally showed restraint and gave back 4.2%. The financial stocks looked less bulletproof this week, with the Broker/Dealers' dipping almost 3% on the back of Morgan Stanley's disappointing earnings report. The resilient Banks added 0.4%. Although bullion gave up 50 cents, the HUI Gold index posted a strong weekly return of 3%.

The Treasury market was finally hit with meaningful serious selling. Two-year Treasury yields jumped 8 basis points to 1.16% and five-year yields rose 23 basis points to 2.26%. Ten-year Treasury yields closed the week at 3.37%, up 25 basis points, while the long-bond saw its yield surge 26 basis points to 4.43%. Benchmark mortgage-back securities had a rough go of it, with yields jumping 30 basis points. The implied yield on agency futures added only 17 basis points. The spread on Fannie's 4 3/8% 2013 note was about unchanged at 36, while the spread on Freddie's 4 ½% 2013 note narrowed almost two to 36 basis points. The benchmark 10-year dollar swap spread increased 2.5 to 37. Interestingly, rising Treasury yields worked to the advantage of corporate relative performance. Junk spreads narrowed sharply this week, with investment grade spreads narrowing moderately. Yields moved higher globally, with European bond yields rising 20-25 basis points. The hot emerging bond market gave up a little ground, with benchmark Mexican yields jumping 28 basis points and Brazilian yields increasing 60 basis points.

The debt issuance boom runs unabated. Bear Stearns this week sold $1.5 billion (up from $750 million) of bonds, Banc One $1 billion, Baltimore Gas & Electric $200 million, Tennessee Valley Authority $500 million, Pitney Bowes $375 million, Petro-Canada $600 million, Vodafone $500 million, United Utilities $250 million, Entergy Arkansas $115 million, DR Horton $100 million, Qantas Airways $450 million and Avon Products $250 million. It was another huge week for junk: Nextel Partners issued $450 million, Centennial Cellular $500 million, Rogers Cable $350 million, Bowater $400 million, Dominos $400 million, Science Applications $300 million, Doubleclick $135 million, Lattice Semiconductor $200 million, Le-Natures $150 million, Psychiatric Solutions $150 million, American Color Graphics $280 million, Arch Western Finance $700 million and Genesco $75 million. It was also quite a week for convertibles: Xerox $800 million (up from $650 million), ICOS $250 million, Cooper $100 million, WebMD $300 million, Advanced Medical Optics $100 million, Amylin Pharmaceuticals $150 million, and Biomarin Pharmaceuticals $125 million.

General Motors will take advantage of over-liquefied markets to issue $13 billion of new debt, $10 billion earmarked for its $25 billion under-funded pension deficit. Part of the issuance includes plans to issue $3.5 billion of convertible bonds maturing in 15 years. While it may help alleviate GM's financial shortfall, issuing securities will not provide the means for feeding and clothing our future retirees.

June 20 - Bloomberg: "Xerox Corp., the world's biggest copier maker, and wireless telephone service provider Nextel Partners Inc. led borrowers in the biggest week for U.S. junk-bond sales in more than two years, as investor demand for the lowest-rated securities pushed down debt costs. Borrowers rated below investment grade - considered to have a higher chance of default - sold about $6 billion of debt this week, the most since May 2001… Offerings by companies rated lower than Baa3 by Moody's Investors Service and below BBB- by Standard & Poor's made up almost half the week's $13.3 billion of total corporate issuance in the U.S… In a sign of investors' increased appetite for risk, about 19 companies rated at or lower than Caa1 by Moody's and CCC+ by S&P - in the lowest third of the junk-ratings scale - have issued bonds so far this year. That's the same number as was sold in all of 2002, according to Bloomberg data. 'Six months ago, there was no chance for those kinds of issues,' said Mike Difley…(of) American Century Investment Management… 'People are looking for yield and are moving down the credit-quality spectrum to find it.' Overall, junk-rated companies have sold $69 billion of debt this year, up from $40 billion in the same period a year agoThe difference in yield between junk bonds and Treasuries has dropped to 6 percentage points on average, the lowest so-called spread since July 2000, according to Merrill Lynch & Co. data. The average absolute yield to maturity on the debt, at 8.9 percent, is the lowest since January 1998…"

June 18 - Bloomberg: "Russia's economy may grow 6 percent in the second quarter and as much as 5.5 percent for the full year of 2003, Economy Minister German Gref said in St. Petersburg. The government official forecast for economic growth for this year was between 4.5 percent and 5 percent. Industrial production grew 8.5 percent in May… 'The positive economic results of the past months of this year strengthen our confidence that the fundamental direction of our policies is correct, (Prime Minister) Kasyanov told the St. Petersburg Economic Forum. Russia's economy expanded 6.4 percent in the first quarter, the fastest growth since the last three months of 2000, as oil, gas and metals producers boosted exports and service companies tapped soaring domestic demand."

June 20 - Bloomberg: "China imported 8.8 percent more crude oil in May than in the same month a year earlier. China bought 6.04 million metric tons of crude oil worth $1.23 billion from abroad last month, compared with $1.04 billion tons last May, customs statistics showed. For the first five months of the year, China's crude oil imports rose 36 percent to 36.15 million tons."

Broad money supply (M3) declined $7.0 billion last week. Demand and Checkable Deposits dipped $2.9 billion, while Savings Deposits added $7.7 billion. Small Denominated Deposits declined $1.7 billion and Retail Money Fund deposits dropped $3.9 billion. Institutional Money Fund deposits declined $3.2 billion and Large Denominated Deposits gained $5.6 billion. Repurchase Agreements dropped $11.3 billion and Eurodollars added $1.0 billion. Elsewhere, Total Commercial Paper outstanding declined $6.9 billion last week. Non-financial CP dipped $2.2 billion and Financial CP declined $4.7 billion. Total Bank Assets jumped another $49.9 billion last week, with seven week gains of $210 billion. Real Estate loans increased $18.6 billion, while Commercial and Industrial loans declined $4.0 billion.

The Mortgage Bankers Association Application index was about unchanged for the week, again at a near-record level. Year-over-year, the Refi index is up 420%. Purchase Application volumes are up almost 18% y-o-y, with the dollar volume up 26.5%. The Purchase Application index is more than double the level from June 1997. The average loan size for a Purchase Application last week was $193,800, and the average adjustable-rate mortgage was for $327,100.

June 14 - Los Angeles Times (Bonnie Harris): "Home prices in Los Angeles County shot up to another record in May, but sales fell significantly from the same month a year earlier amid a rapidly diminishing supply of less-expensive homes. The median sales price of new and existing homes in L.A. County jumped 21% on a year-over-year basis to $313,000 last month, according to…DataQuick. All categories of homes showed strong appreciation: Existing single-family houses rose 20% to $325,000, and new homes climbed 22% from a year earlier to $400,000. Condominiums, the most affordable option for home buyers, posted the largest gain, increasing 25% to $245,000. Actual sales in the county, however, dropped almost 8% to 10,863 properties. Housing experts and brokers said the slowdown wasn't a sign of weakening demand; rather, they blamed it on a persistent shortage of homes for sale and a storm of refinancings that is clogging up the system and delaying escrow closings… DataQuick said the biggest sales drop in May, about 28%, came in the segment of homes priced below $300,000. With fewer lower-priced properties on the market, sales tumbled in areas such as San Fernando, Covina and South-Central Los Angeles. 'Clearly there is a massive supply constraint in that segment, and unfortunately it's the more affordable segment,' said G.U. Krueger, research director at Institutional Housing Partners… 'Buyers are essentially skipping over that range and going straight to the next level.'"

May Housing Starts and Building Permits were both reported stronger-than-expected. Starts jumped 6% from April, with Multi-family Starts the strongest since November. Permits increased 4% to the strongest pace since December. Housing Completions jumped 10% over two months to the strongest level since January 1987. For comparison, May Housing Completions were up 27% from May 1997, and were almost 80% above the trough level from late 1991. Units under construction were up 3.1% y-o-y, with Single-family up 5.2% and Multi-family down 1.3%. By region, the Northeast was down 0.1%, the Midwest up 7.3%, the South up 1.7%, and the West up 3.5%. The National Association of Home Builders index jumped five points in May to the highest reading since February. The Future Sales (next six months) component gained seven points (up 13 points in two months) and has not been higher since November.

The Consumer Price Index was unchanged (core up 0.3%) for the month and up 2.1% y-o-y. By category, Food prices were up 1.7% y-o-y, Transportation 2.2%, and Recreation 1.1%. Apparel prices were down 3.6% and Computers sank 21.7% y-o-y. Energy prices increased 9% y-o-y, Medical Care 4%, and Housing 2.7%. The quite moderate Medical and Housing price increases lack credibility.

June 18 - Wall Street Journal (Greg Ip): "Statistical quirks may be the cause. To compute the cost of home ownership, the Bureau of Labor Statistics examines the rental market to estimate how much an owner could charge to rent out his house, and calls this 'owners' equivalent rent.' Some rents include the cost of natural gas, so the bureau subtracts estimated gas charges from them. But in practice, rents often stay the same when gas charges fluctuate. That means when the cost of gas soars, as it has this year, owners' equivalent rent appears to drop, or in any event rise less rapidly than regular rents, which aren't affected."

After eight months of the fiscal year, federal government receipts are down 4.8% from comparable 2002. Individual Income Taxes have declined 7.9% and Corporate Taxes have sunk 26.7%, partially offset by a 2.2% increase in Social Insurance receipts. Year-to-date spending increased by 6.4%. By largest department: Social Security was up 4.1%, Health & Human Services 8.2%, Defense up 15%, Agriculture up 3.1%, Labor 13%, and Education 23.9%. Interest payments declined 3.8%. The year-to-date deficit of $292 billion is double last year's. Goldman Sachs this week increased their estimate for the full-year deficit to $475 billion.

Several of the major Wall Street securities firms have quarters ended May 31st. So we were this week provided with a good indication for how aggressively the financial sector is playing the Fed-orchestrated "easy money" environment.

From Bear Stearns: "Fixed Income net revenues were $765.2 million, up 47.5% from $518.6 million reported for the quarter ended May 31, 2002. The Fixed Income Division continued to benefit from a low interest rate environment, a steep yield curve, a narrowing of corporate credit spreads and high market volatility. Record revenues were achieved again in both the credit and interest rate product areas. The high yield, high grade, distressed and foreign exchange areas all produced strong results. In addition, mortgage-backed securities revenues continued to perform well."

From Morgan Stanley: "Fixed income sales and trading net revenues increased 48 percent from second quarter 2002 to $1.3 billion. The increase resulted from strong performances across the Company's credit products, interest-rate and currency products, and commodity groups. The revenue increases in credit and interest rate products reflected tighter spreads, strong investor demand and an improved trading environment."

From Lehman Brothers: "The Firm's Fixed Income Capital Markets business recorded its highest level of quarterly revenues ever, driven by increased customer flow activity across most products, including derivatives, credit products, and mortgages." Principal Transaction Revenues, or "trading with its own money," surged to $1.275 billion. This was up 66% from the previous quarter and double the year ago quarter. By business segment, Capital Markets Fixed Income Net Revenue surged 75% y-o-y to $1.186 billion. Compensation jumped 34% sequentially.

It is also worth noting that Lehman expanded Total Assets during the quarter by $35.7 billion to $304 billion, a record increase and a notable 53% annualized growth rate. Lehman Total Assets have doubled since the beginning of 1998 (22 quarters). We see that Morgan Stanley expanded Total Assets by $27.5 billion, or 20% annualized, to $587 billion during the quarter. Morgan Stanley Assets are up 94% since 1998. With the securities firms and banks so aggressively expanding, second-quarter Financial sector borrowings are sure to accelerate from the first quarter's 9.7% annualized pace. There is then no mystery surrounding the source for the torrent of liquidity sloshing around the markets.

We are reading that there's now nothing but clear skies ahead for a multi-year bull market. Ignore the pessimists and aggressively buy stocks we are told. Failsafe models say that the only risk is not jumping on board the new bull. Well, I will avoid climbing out on a limb and predicting when this liquidity-driven rally will fizzle, but anyone who dismisses the great and escalating risks inherent to our fragile financial system and maladjusted economy is not doing his homework. There will be an enormous loss of financial wealth over the coming years, and this most atypical environment is poised to ambush those fearless model adherents.

June 17 - Financial Times - Commentary from American economist David Hale: "One of the most remarkable features of the current financial cycle has been the resilience of the US banking system. It has performed far better over the past two years than during the recession of 1990-91 and after previous periods of great stock market weakness. In the last economic slump, there was a big upsurge of bank failures. In 1989, there were 205 bank failures, 160 in 1990 and 109 in 1991. During the present cycle, bank failures have been very rare. There were seven in 2000, four in 2001, 11 in 2002 and two so far this year… There are four main factors that explain why the current cycle has not been accompanied by big bank failures. First, there was far less margin borrowing during the recent stock market bubble than during the bubble of the late 1920s. At the peak in March 2000, margin debt was less than 2 per cent of gross domestic product. At the peak in late 1929, margin debt was nearly 9 per cent of GDP… Second, the banking system did not finance the speculative capital-spending boom that drove the economy's growth during the late 1990s. It was financed instead through a process of securitisation that transferred risk from banks to insurance companies, mutual funds, pension funds and retail investors… Third, US banks restrained themselves from property lending during the recent cycle far more than they did during previous business cycles… Last, the overall level of loan delinquency was only 3.99 per cent in the most recent quarter - compared with 5.38 per cent in the early 1990s - because of a strong performance by the US corporate sector… It is the resilience of America's banks, not just the Federal Reserve's monetary policy, that will set the stage for economic recovery later this year."

There are of course valuable insights garnered from comparing recent financial and economic experiences to the Roaring Twenties excesses and their horrid consequences. Certainly, the dynamic of unsound financial and economic underpinnings impelling catastrophic central bank accommodation is at the top of the list. But contemporary analysts have been ensnared in one critical analytical trap: They've got the wrong Bubble! The stock market was the epicenter for the gross leveraging and speculation during the late twenties (the key dysfunctional Monetary Process), with its collapse setting in motion powerful debt deflation dynamics. However, for the recent episode of historic financial folly, the U.S. Credit system is definitely at the "epicenter." Sanguine "post-Bubble" analysis begins with the mistaken premise that THE Bubble has in fact burst. It has not.

And before we get too carried away with regard to the "resilience" of our banking system, let's keep in mind that Total Bank Assets have expanded about 12% over the past year and are up 50% since the beginning of 1998. Real Estate loans are up 17% over twelve months and 43% since the beginning of 2000. As always, delinquencies and losses are seductively well-behaved during the boom. But they will surge with the inevitable abatement of lending excesses - exactly the nature of boom and bust dynamics. And while current runaway excesses would be expected to spark an "economic recovery later this year," there are more poignant issues. First, why's the economy been so despondent even to rampant financial excess? Second, will an upsurge in activity be sustainable or a further destabilizing flash in the pan?

Understandably, many are amenable to the notion that the financial system and economy are now begrudgingly emerging from a bad spell similar to that experienced in the early nineties. And following this line of reasoning, it's less painful this go round compared to the early nineties specifically because the system is today more robust and stable. We take strong exception, arguing that it is much more a case of the Fed and an aggressive U.S. financial sector thus far postponing the greater part of the necessary adjustment.

And while there are similarities to the early nineties (including the Greenspan Fed "changing the rules" to enhance financial profits, speculation, and Credit growth), I believe the differences are today more worthy of contemplation. Importantly, the early nineties economic stagnation and financial dislocation were part of a wrenching adjustment period necessary to work through (financially and economically) post-eighties excesses. The Milken junk bond juggernaut, including Drexel Burnham, collapsed in disrepute. The reckless real estate lenders from the Northeast and California collapsed, along with scores of (flimflam) Savings and Loans. The lending spigot that that been aggressively financing asset Bubbles, unprofitable business enterprise, and fraudulent endeavors was largely shut down. There was painful dislocation, the Credit system was brought to its knees, and punishment was meted out for previous misdeeds. Dysfunctional financing mechanisms were (somewhat) squelched and more disciplined lending practices returned to vogue, setting the stage for expansion.

Today, rather than trumpet the lack of recent bank failures as an indication of a wholesome and vibrant financial system, we'll protest that myriad misdeeds have gone unpunished. We don't see any major lenders, even those that cohabitated with the Enrons and Worldcoms of the world, in any hot water today. Looks like more of the same - business as usual. And as long as the Fed grants amnesty for most past, current, and future financial transgressions, the allure of easy gains will naturally perpetuate unsound excess. And that's an enormous systemic problem - the insoluble dilemma that will come back and bite the bullish optimists where it counts. Again, the story remains that the system is hopelessly unsound, and we are left to look nervously to the future for the inevitable post-Bubble adjustment period. Yet there is great pressure today to stick one's head in the sand and disregard an only increasing financial fragility.

The harsh reality is that our fragile financial system and maladjusted economy are sustained only by enormous financial sector expansion. It receives no attention, but the paramount issue is the enormity of the new Credit necessary to achieve only minimal economic expansion, and how monstrous the financial sphere has become since the commencement of the previous (early nineties) business recovery.

First of all, Total Credit Market Debt (financial and non-financial) as a percentage of GDP has surpassed 300%, compared to 240% back in 1990. How about 400% by 2008? Total Credit Market Debt has increased almost 8% over the past year, compared to 4.7% during the year 1991. 1991's Total Credit Growth of $648 billion, or 11% of GDP, compares to 2002's $2.3 Trillion, or 22% of GDP. Comparing Non-financial Credit growth, 1991's $462 billion, or 4.3% increase, is about one-third 2002's $1.385 Trillion, or 7.2% increase. And contrasting Non-financial Credit growth as a percentage of GDP, 2002's 13% compares to 1991's 8%.

Comparing the growth in Total Financial Sector Borrowings, 1991's $171 billion (2.9% growth rate) is about 18% of 2002's increase of $924 billion (9.8% growth rate). In a truly historic inflation of financial claims, Total Financial Sector borrowings increased from 1991's 47% of GDP ($2.8 Trillion) to today's 99% ($10.6 Trillion). Observing Total Bank Assets, we see 1991 growth of 2.5% ($83 billion) and 1992's 2.8% ($95 billion). This annual growth was about 1.5% of GDP. In contrast, Bank Total Assets have surged $807 billion, or 12.4%, over the past year. This is approaching 8 % of GDP. Analyzing "Structured Finance," or the GSE, ABS, and MBS sectors, we see that combined assets increased about $230 billion (growth of about 3.5% of GDP) both during 1990 and 1991. And Structured Finance ended 1991 at $2.0 Trillion, or 33% of GDP. During 2002, Structured Finance assets increased $838 billion, or growth equal to 8% of GDP, and ended 2002 with total assets of $8.1 Trillion, or 77% of GDP.

As we appreciate, this intractable financial inflation has fueled (unsustainable) over-consumption, intractable current account deficits, and an unprecedented accumulation of foreign-held claims on our economy. The $510 billion Current Account deficit over the past four quarters compares to 1991's $7 billion surplus. But, then again, balancing one's trading position is a fundamental aspect of the post-boom adjustment process.

We see that the Rest of World increased holdings of US financial assets by $99.5 billion during 1990 and $131 billion (2.2% of GDP) during 1991. Total Rest of World holdings ended 1991 at almost $2 Trillion, or 34% of GDP. "The World" increased holdings of U.S. financial assets by $523 billion (5% of GDP) last year to $7.48 Trillion, or 72% of GDP. These holdings have surged 54% since the beginning of 1998.

In my mind, the Critical Issues seem to be crystallizing by the week: First, is it sound analysis to presume that the financial sector will maintain at least its current rate of expansion, in the process creating the Credit necessary to stimulate a "recovery"? Second, will foreign Creditors continue to accommodate this inflation by acquiring only larger quantities of devalued dollar claims?

One can always justify the assumption that the future will look much like the recent past. In this case, that the financial sector will continue to effortlessly inflate financial claims, which our foreign creditors will gladly accumulate. Well, in the past I wrote a piece titled "How could Irving Fisher have been so Wrong?" Why did America's preeminent economist see permanent prosperity when the system was rapidly approaching the financial and economic abyss? Well, as I see it, he made the common but fatal analytical error of extrapolating the spectacular effects emanating from a terminal period of gross financial excess. Many are today merrily Following in Dr. Fisher's Footsteps.

It is my view that a multi-year extension of the financial sector Bubble expansion is fraught with such danger that it is very likely unattainable. Yes, it has expanded by about 90% over five years, while the recent 10% annualized growth rate proceeds swimmingly. And, sure, over the past five years foreign Creditors have increased U.S. financial asset holdings by almost 55%. But I would argue that we are today well into the terminal stages of the financial sector inflation and foreign holders' tolerance with this claims debasement.

Keep in mind that this historic financial inflation has unfolded during a collapsing rate environment. The supply of new financial claims has been enormous and necessarily unrelenting, yet demand for these price-inflating assets has been even more intense. This will prove an anomaly. Despite rumblings of possible "unconventional" policy measures, the Fed has about run out of room to inflate Credit market prices. And while the dollar has declined meaningfully over the past 18 months, our foreign creditors' currency losses have been heavily mitigated by surging bond prices. But going forward I don't envisage runaway financial sector expansion functioning smoothly in a stable or rising rate environment. Moreover, the Fed's desperate move to manipulate market perceptions, collapse interest rates, and debase the dollar was necessarily too conspicuous.

June 17 - Bloomberg: "Jamaludin Jarjis, Malaysia's second finance minister, comments on…Malaysia's ringgit peg and euro: 'The peg is working nicely for us. Our concern is our competition with China. Malaysia should remain competitive. The moment our products lose competitiveness with other countries in Asia, then we really will have to look at it. Now, we are comfortable. 'Of course, we have to be careful on our assets because if we keep our assets in U.S. dollars, they will be depreciated in value. 'On the debt side, it's okay, they can be in U.S. dollars. But all the revenue should be in euro. Debt obligations can remain in U.S. dollars, but we advise corporations their revenue should be in euros. Government agencies have been advised already.'"

The World is now keen to dollar debasement. And while global central bankers have of late risen to the occasion and accumulated massive dollar holdings unwanted by the international private sector, this is one more development that should not be trumpeted nor extrapolated. It is a sign of impending trouble (diminishing private demand for dollar claims), but that for now ironically acts to foster global over-liquefication. Yet the day Japanese, Chinese, Asian and other central banks loose their appetite for these inflating dollar balances will mark a key inflection point in financial history. And we don't see it taking several years.

The stock market optimists today see nothing but blue skies, while unwittingly extrapolating the effects from the terminal stage of rampant Credit inflation and the Fed's desperate measures to prolong it. How quickly they forget that it wasn't all too many months ago that unfolding financial crisis had the Fed terror-stricken. Our (and global) central bankers responded by hitting the panic button, provoking an abrupt and dramatic change in market perceptions. Almost overnight, the Fed's maneuver made it more profitable to be long Ford bonds rather than to be short them; much more enticing to be leveraged in junk bonds and converts than to be short stocks. But be especially careful extrapolating today's extreme over-liquefication, and don't mistake liquidity effects for true financial or economic regeneration. Pushing the panic button certainly didn't cure anything. Rather, there's been a confluence of one heck of a short-squeeze and rampant leveraged Credit market speculation, with the Bubble granted one more new lease on life.

The Achilles Heel of Financial Fragility is only further imperiled by the Fed negligently inciting manic behavior that will, again, end in disappointment and revulsion. That's the inherent nature of speculative markets, manipulated but not subverted by Fed actions. Yes, the historic financial sector expansion has accelerated, but the nature of the dynamics fueling today's liquidity excesses are much more likely of a late-stage "blow-off" variety than the (early nineties-style) beginning of a new Credit cycle. After all, the preponderance of Credit creation nowadays continues to finance real estate, household consumption, and leveraged speculation. These "sectors" have been over-borrowing for years. The probability that current excesses throughout mortgage finance can be sustained for a few more years is remote.

And, importantly, there are further indications that years of aggressive financial sector expansion is increasingly problematic. We certainly don't expect the major issues of derivative accounting and the lack of transparency to end with Freddie Mac. Is the Pandora's Box of financial accounting about to be unlatched? Yesterday, Countrywide Financial released a statement that "management firmly believes that there is no basis whatsoever for these rumors ("related to accounting matters and its financial statements") and stands behind the integrity of its accounting practices." Well, the company's balance sheet has ballooned 73% over the past four quarters to $73.6 billion (up from $15.8 billion to end year-2000). This expansion is a microcosm of the U.S. financial sector, with ballooning assets of indeterminable true economic value. And with interest rates at such extreme lows and leveraged speculation conspicuous, going forward we would expect the marketplace to look at huge trading positions and inflating balance sheets with a more skeptical eye.

And if this week's reversal proves to a major turn in yields, then U.S. financial sector expansion has surely commenced a much more arduous period. A strong case can be made that the requisite financial sector expansion will function effectively only in a stable or declining interest rate environment. The Fed has thrown one heck of a party, with fun and games and gifts galore. We don't think the best is yet to come.

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