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Q3 2006 Flow of Funds

Really unedited, but will be less so by about 9:15 Central Time!

For the week, the Dow and S&P500 gained 0.6%, increasing y-t-d gains to 14.8% and 12.9%. The Transports added 0.3%, while the Utilities were unchanged. The Morgan Stanley Cyclical index jumped 1.8%, and the Morgan Stanley Consumer index rose 2.2%. The small cap Russell 2000 gained 1.5%, and the S&P400 Mid-Cap index added 0.8%. The NASDAQ100 and Morgan Stanley High Tech indices both gained 0.6%. The Semiconductors rose 0.7%. The Street.com Internet Index dipped 0.2%, while the NASDAQ Telecommunications index rose 2% (up 27.7% y-t-d). The Biotechs added 0.6%. Financial stocks were strong. The Broker/Dealers jumped 3.7% (up 24.4% y-t-d) and the Banks gained 1.6% (up 9.9% y-t-d). With Bullion down $20.40, the HUI Gold index dropped 2.5%.

Two-year government yields rose 15 bps to 4.675%. Five-year yields increased 14 bps to 4.52%, and 10-year Treasury yields 11.5 bps to 4.55%. Long-bond yields rose 11 bps to 4.66%. The 2yr/10yr spread ended the week inverted 12.5 bps. The implied yield on 3-month December '07 Eurodollars jumped 20 bps to 4.745%. Benchmark Fannie Mae MBS yields surged 20 bps to 5.69%, this week underperforming Treasuries. The spread on Fannie's 5 1/4% 2016 note ended the week three wider at 34, and the spread on Freddie's 5 1/2% 2016 note two wider at 31. The 10-year dollar swap spread increased 2.8 to 49.3. Corporate bond spreads were volatile, although junk spreads finished the week moderately narrower.

It was another week of heavy corporate debt issuance. Investment grade issuers included American Express $2.0 billion, Prudential $2.0 billion, HSBC $2.0 billion, Nakilat $1.35 billion, Simon Properties $1.25 billion, Diageo Capital $600 million, Washington Mutual $500 million, National City $500 million, Nationwide Life $425 million, Southern Cal Edison $400 million, Cleveland Electric $300 million, Allied Capital $250 million, Nationwide Life $200 million and Georgia Power $150 million.

December 6 - Bloomberg (Mark Pittman and Elizabeth Hester): "Ford Motor Co., under pressure to raise money to close plants and pay for employee buyouts, increased the sale of bonds that can be converted into shares by 50 percent to $4.5 billion... The offering combined with a boost in the size of a credit line that Ford is seeking means the automaker will raise as much as $23 billion to carry it through next year's union negotiations, up from the $18 billion it originally planned."

Junk bond funds saw inflows of $267 million this week. Junk issuers included Williams Partners $600 million, Regency Energy $550 million, United Auto Group $375 million, Empire Resources $335 million, Buffalo Thunder $245 million, and Newmarket $150 million. "Junk" preferred issuers included Ford $4.5 billion.

Convert issuers included Sesi LLC $400 million, Orbital Sciences $145 million, First Potomac $110 million, Mannkind $100 million, and Acadia Realty $100 million.

International dollar debt issuers included Opti Canada $1.0 billion, Aiful Corp $500 million, and True Move $465 million.

Japanese 10-year "JGB" yields jumped 9 bps this week to 1.69%. The Nikkei 225 index increased 0.6% (up 1.9% y-t-d). German 10-year bund yields rose 6 bps to 3.72%. Emerging markets were mostly higher. Trading at record low yields, Brazil's benchmark dollar bond yields declined 4 bps this week to 5.99%. Brazil's Bovespa equities index surged 4.0% this week (up 28.5% y-t-d). The Mexican Bolsa gained 3.2%, increasing 2006 gains to 44.7%. Mexico's 10-year $ yields declined 3 bps to 5.50%. Russia's 10-year Eurodollar yields dipped one basis point to 6.54%. The Russian RTS equities index gained 3.9% (up 64.4% y-t-d). India's Sensex equities index dipped 0.3%, reducing 2006 gains to 46.8%. China's Shanghai Composite index slipped 0.4%, lowering y-t-d gains to 80.3%.

Freddie Mac posted 30-year fixed mortgage rates dipped 3 bps to 6.11%, down 21 bps from one year ago to the lowest level since January 20. Fifteen-year fixed mortgage rates declined 3 bps to 5.84% (down 3bps y-o-y). And one-year adjustable rates fell 3 bps to an 8-month low 5.43% (up 27 bps y-o-y). The Mortgage Bankers Association Purchase Applications Index jumped 4.9% this week to the highest level since May. Purchase Applications were still down 13.8% from one year ago, with dollar volume 14% lower. Refi applications jumped 13.7%. The average new Purchase mortgage increased to $228,100 (down 6.7% y-o-y), and the average ARM jumped to $381,500 (up 4.7% y-o-y).

Bank Credit surged $42.9 billion last week (2-wk gain of $65.6bn) to a record $8.233 TN. Year-to-date, Bank Credit has expanded $727 billion, or 10.5% annualized. For the week, Securities Credit increased $5.7 billion. Loans & Leases jumped $37.3 billion, with a y-t-d gain of $550 billion (10.9% annualized). Commercial & Industrial (C&I) Loans have expanded at a 13.8% rate y-t-d. For the week, C&I loans were little changed, while Real Estate loans rose $12.0 billion. Real Estate loans have expanded at a 14.5% rate y-t-d. For the week, Consumer loans increased $5.0 billion, and Securities loans jumped $19.4 billion. Other loans added $0.9 billion. On the liability side, (previous M3 component) Large Time Deposits increased $1.2 billion.

M2 (narrow) "money" supply rose $19.9 billion to a record $6.991 TN (week of 11/27). Year-to-date, narrow "money" has expanded $305 billion, or 4.9% annualized. For the week, Currency added $1.1 billion, and Demand & Checkable Deposits increased $10.1 billion. Savings Deposits increased $2.1 billion, and Small Denominated Deposits gained $1.2 billion. Retail Money Fund assets increased $5.3 billion.

Total Money Market Fund Assets, as reported by the Investment Company Institute, jumped $28.6 billion last week to $2.358 Trillion. Money Fund Assets have increased $301 billion y-t-d, or 15.5% annualized. It is also worth noting that Money Fund Assets have expanded at a 23.2% rate over the past 20 weeks.

Total Commercial Paper increased $4.8 billion last week to $1.933 Trillion. Total CP is up $292 billion y-t-d, or 18.9% annualized. Total CP has expanded at a 21% rate over the past 20 weeks.

Asset-backed Securities (ABS) issuance this week increased to $17 billion. Year-to-date total ABS issuance of $693 billion (tallied by JPMorgan) is running about 7.6% below 2005's record pace, with 2006 Home Equity Loan ABS sales of $458 billion about 6% under comparable 2005. Also reported by JPMorgan, y-t-d US CDO (collateralized debt obligation) Issuance of $333 billion is running 80% ahead of 2005.

Fed Foreign Holdings of Treasury, Agency Debt added $1.3 billion during the week to a record $1.713 Trillion (week of 12/06). "Custody" holdings were up $193.5 billion y-t-d, or 13.5% annualized. Federal Reserve Credit declined $1.6 billion to $842.4 billion. Fed Credit is up $16.0 billion y-t-d, or 2.1% annualized.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $748 billion y-t-d (19.6% annualized) to a record $4.794 Trillion.

Currency Watch:

December 8 - MarketNewsInternational: "The US dollar is facing downside risk if capital stops flowing into the United States on concerns of its current account deficit, the People's Bank of China said in a report... 'If US current account deficit continues to grow faster than its GDP growth, the investment value of US assets may be questioned and challenged and investors' willingness to hold US financial assets will drop... There is the possibility of a sharp US dollar depreciation if foreign funds stop flowing into the US'... It also said excess liquidity is a global issue mainly because of the US and Japan's long-term expansionary monetary policies as well as the high savings rates of Asian and OPEC countries."

December 6 - Bloomberg (Marc Wolfensberger): "Iran, the world's fourth-largest oil exporter, plans to reduce its use of the U.S. dollar in world trade and increase use of the euro, two Tehran-based newspapers reported. The Tehran Times said today Iran has started substituting euros for dollars in oil sales, citing an unidentified person at the Oil Ministry. Iran Daily reported Iran wants to cut its dollar-based transactions to a minimum, citing Minister of Economy Davoud Danesh-Ja'fari."

The dollar index rallied 1.1% to 82.30. On the upside, the South African rand increased 2.1%, the Mexican peso 1.9%, the Turkish lira 1.6%, the Malaysian ringgit 1.3%, and the Brazilian real 1.3%. On the downside, the Iceland krona declined 2.8%, the Polish zloty 1.7%, the Swedish krona 1.4%, the British pound 1.3%, and the Euro 1.0%.

Commodities Watch:

December 4 - Bloomberg (Helen Yuan): "China, the world's third biggest gold consumer, is expected to use 17 percent more of the precious metal this year as investment demand has grown, the head of the China Gold Association said. China's gold consumption is expected to rise to 350 metric tons from 300 tons in 2005..."

December 5 - Financial Times (Kevin Morrison and Mariko Sanchanta): "Voracious demand from China for steel is likely to lift prices for iron ore further when negotiations for the coming year are concluded... China, the world's leading importer of contract ore, is set to lead the negotiations for benchmark prices for 2007, reflecting the country's new clout as the world's biggest buyer of raw materials. Last year, Nippon Steel, Asia's leading stalemated, set the benchmark when it agreed a 71.5 per cent price increase for iron ore from Brazil's CVRD. The talks are expected to confirm what analysts at Citigroup in Sydney described as 'the changing of the guard', with China replacing Japan as the key price determinant. Having surpassed Japan in 2004 as an importer, China now buys about half of all seaborne iron ore."

Gold dropped 3.2% to $625.20, and Silver fell 2.5% to $13.84. Copper declined 2.0%, reducing y-t-d gains to 61%. Tin prices rose to a 17-year high. January crude declined $1.31 to end the week at $62.12. January Unleaded Gasoline declined 3.6%, and January Natural Gas sank 10.2%. For the week, the CRB index declined 2.8% (down 5.9% y-t-d), and The Goldman Sachs Commodities Index (GSCI) fell 3.5% (up 3.3% y-t-d).

Japan Watch:

December 4 - Bloomberg (Lily Nonomiya): "Japanese companies increased spending at a slower pace in the third quarter, suggesting the government may lower its growth estimate for the economy this week. Investment rose 12 percent in the three months ended Sept. 30... Profits climbed 15.5 percent, the fastest pace in two years."

December 7 - Bloomberg (Anand Krishnamoorthy): "Airbus SAS, the world's largest planemaker, increased its forecast for new plane orders in India because of rising demand in the country, set to become the world's fastest-growing air travel market in the next decade. The planemaker...said India will need 1,100 planes until 2025..."

China Watch:

December 6 - MarketNewsInternational: "China booked a trade surplus of $157 bln for the first 11 months of this year, $66 bln more than the same period of last year... Xinhua reported earlier Wednesday that the trade surplus for November alone was $23.37 bln, a slight fall from October's record $23.83 bln surplus. Exports for the January-November period rose 27.5% to $875 bln while imports were up 20.5% to $718 bln..."

December 5 - Bloomberg (Josephine Lau): "China's retail sales will grow about 13 percent to 8.6 trillion yuan ($1.1 trillion) next year...That would be a slowdown from the 2006 forecast of 13.5 percent by the Ministry of Commerce last month."

India Watch:

December 8 - Bloomberg (Anil Varma): "Indian banks' loans increased by 126.4 billion rupees ($2.8 billion) in the two weeks ended Nov. 24... Credit climbed 28.8 percent...in the 12 months... Total deposits rose by 21.4 percent..."

Asia Boom Watch:

December 1 - Financial Times (Tom Mitchell): In a region where a Chinese bank looking to raise $22bn can attract half a trillion dollars in initial public offering of shares orders, $19.4m does not seem that much for a piece of porcelain. The price paid for an 18th century imperial Chinese 'swallows' bowl at the Hong Kong auctions of Christie's this week - a world record for a Qing dynasty ceramic - is a reminder that Industrial and Commercial Bank of China's mega-IPO in October was just one facet of an investment craze sweeping Asia. 'What's happening to us is symptomatic of what's happening to the world,' says Edward Dolman, Christie's chief executive. 'It's being driven by the extraordinary amounts of cash that are around. It's a great time to be selling art.' The London-based auction house tallied sales totalling more than $363m at its spring and autumn Hong Kong auctions this year, compared with just $100m in 2003. Rival Sotheby's, which concluded its biannual auctions in the territory in October, realised sales of $246.5m. Records fell fast and furiously at both houses, for everything from early 15th century Sino-Tibetan gilt bronze sculptures to modern Chinese oil paintings. Mr Dolman credits the nouveaux riches of China and India for the current Asian art boom..."

December 4 - Financial Times (Florian Gimbel): "Asia-based private banks are paying newly-hired senior bankers up to $1m in annual compensation for the first time, in a move that is expected to lift pay levels beyond the records set in the dotcom boom. Average year-end bonuses for client relationship managers are expected to jump 40% this year, while average total compensation is expected to increase 20%, says the Boston Consulting Group. The sharp rise in bonuses is a reflection of an increasingly expensive war for scarce Asian private banking talent..."

December 7 - Bloomberg (Theresa Tang and James Peng): "Taiwan's export growth picked up in November as sales to China rose and gains in the euro spurred European demand for the island's electronics. Overseas sales increased 8.2 percent from a year earlier to $19.5 billion..."

Unbalanced Global Economy Watch:

December 6 - Associated Press: "The richest 2% of adults still own more than half the world's household wealth, perpetuating a yawning global gap between rich and poor, according to research... The report from the Helsinki-based World Institute for Development Economics Research shows that in 2000 the richest 1% of adults - most of whom live in Europe or the U.S. - owned 40% of global assets. The richest 10% of adults accounted for 85% of assets..."

December 7 - Bloomberg (Jennifer Ryan and Craig Stirling): "U.K. house-price inflation accelerated to the fastest pace in 20 months in November, a sign the Bank of England's increase in borrowing costs to the highest since 2001 hasn't curbed demand in the residential property market, a survey by HBOS Plc showed."

December 5 - Financial Times (Bertrand Benoit and Ralph Atkins): "The era of German wage restraint, a key factor in boosting companies' competitiveness in recent years, may be coming to an end. Leading politicians, trades unions and even some employers are beginning to push for higher pay. IG Metall, the engineering sector trades union, intends to call for a wage increase of between 5 and 8 per cent... Franz Müntefering, the Social Democratic vice-chancellor...and Kurt Beck, the SPD chairman, have called on companies to share rising profits with workers. 'The recovery is here,' Mr Müntefering told the Bild... 'We must now have the courage to drive the [wage] spiral upwards.'"

December 7 - Bloomberg (Simone Meier): "Swiss unemployment unexpectedly declined in November to the lowest in almost four years as the central bank prepares to raise interest rates further. The jobless rate, adjusted for seasonal swings, fell to 3.1% from 3.2%..."

December 5 - Bloomberg (Tasneem Brogger): "Denmark's economy will probably expand 3.3 percent this year, faster than previously forecast, while government plans to raise spending fuel the risk of overheating, the Danish Wise Men said..."

December 7 - Bloomberg (Tasneem Brogger): "Denmark's jobless rate dropped to 4.1 percent in October, stoking concern that a labor shortage will lead to higher wages and inflation."

December 5 - Bloomberg (Robin Wigglesworth): "Norway's economic growth slowed to 0.9 percent in the third quarter as a worsening labor shortage led some companies to limit production. The pace of quarterly growth...fell from 1.1 percent in the previous three months..."

December 5 - Bloomberg (Garfield Reynolds): "Russia' Economy Ministry increased its forecast for 2006 economic growth to 6.8 percent, faster than its initial forecast for 6.6 percent, citing rapid expansions in consumer and investment spending."

December 8 - Bloomberg (Aaron Eglitis): "Latvia's economy expanded 11.8 percent in the third quarter, the fastest pace in the European Union, bolstered by surging consumer demand and construction."

December 6 - Bloomberg (Hans van Leeuwen and Gemma Daley): "Australia's economy grew at its slowest pace in three years in the third quarter as business spending dropped and the nation's worst drought in a century cut farm output. Gross domestic product rose 0.3 percent from the previous three months..."

Latin American Boom Watch:

December 6 - Bloomberg (Peter Wilson): "Venezuela plans to boost spending on basic industries, such as steel and mining, by 30 percent next year as part of a plan to diversify the oil-dependent economy."

Bubble Economy Watch:

December 6 - Bloomberg (Daniel Hauck): "Stock sales by America's corporate chieftains exceeded purchases last month by the widest margin since 1987... Executives...in aggregate sold $63.18 of shares for every $1 they bought in November, an analysis by Bloomberg of data from the Washington Service showed. That's the highest since at least January 1987."

December 8 - Bloomberg (Aaron Kuriloff): "The New York Giants and Jets received approval for $300 million in National Football League stadium loans, a major step toward building a shared $1.2 billion home field in the New Jersey Meadowlands."

Real Estate Bubble Watch:

December 5 - The Wall Street Journal (Ruth Simon and James R. Hagerty): "Americans who have stretched themselves financially to buy a home or refinance a mortgage have been falling behind on their loan payments at an unexpectedly rapid pace. The surge in mortgage delinquencies in the past few months is squeezing lenders and unsettling investors world-wide in the $10 trillion U.S. mortgage market. The pain is most apparent in subprime mortgages, though there are signs it is spreading to other parts of the mortgage market."

December 6 - Bloomberg (Sharon L. Crenson): "There's no housing slump in Manhattan, according to a survey from the Real Estate Board of New York. The median price of an apartment in Manhattan...rose 6 percent in the third quarter to $767,000, the board said... 'The health of Manhattan's residential market remains solid,' Steven Spinola, president of the board, said..."

M&A and Private-Equity Bubble Watch:

December 6 - Financial Times (David Oakley): "Corporate acquisitions and leveraged buy-outs have propelled the trillion-dollar syndicated loans market to record levels as companies take advantage of cheap debt and strong liquidity across the globe. Syndicated lending so far this year has hit $3,337bn compared with $3,079bn for the same period in 2005, an increase of 8 per cent, according to Dealogic... This figure - which includes both investment grade and leveraged finance - is nearly twice the value for the same period in 2003... Richard Howell, co-head of leveraged finance in Europe at Lehman Brothers, said: 'Leveraged buy-outs and corporate-to-corporate mergers and acquisitions, plus new areas of finance such as infrastructure, are driving syndicated loans in a benign credit market where companies and sponsors can borrow on very attractive terms.' Dealogic also found that syndicated lending had risen sharply in the emerging markets of the Middle East, Africa, south-east Asia and the Caribbean."

Financial Sphere Bubble Watch:

December 1 - Financial Times (David Wighton, Ben White and Deborah Brewster): "The importance to Wall Street of a handful of large hedge funds was starkly illustrated by the disclosure that Citadel Investment Group paid more than $5.5bn in interest, fees and other investment costs last year. Although the net asset value of Citadel's two funds is only about $13bn, its costs are high because its managers trade frequently and take on huge leverage. More than 90 per cent of the investment expenses represent interests payments, including the cost of the roughly $100bn of net debt provided by investment and commercial banks. Citadel had gross assets at the end of August of $166bn, representing leverage of 12.5 times."

Speculator Watch:

December 6 - Bloomberg (Katherine Burton and Jenny Strasburg): "Nicholas Maounis, founder of the Amaranth Advisors LLC hedge fund, made a decision in April 2005 that eventually cost him his firm. His promising natural-gas trader, Brian Hunter, had been offered a $1 million bonus to join Steven Cohen's SAC Capital Advisors LLC. Maounis...didn't want Hunter to go. Convertible bond and equity prices were falling and oil and natural gas prices were increasing, making Hunter's expertise more valuable. So Maounis named Hunter co-head of the energy desk and gave him control of his own trades. Hunter, within 17 months, would be responsible for $6.6 billion in losses, detonating the biggest hedge fund implosion ever."

Q3 2006 Flow of Funds:

Akin to current economic and market analysis, skillful examination of the Fed's quarterly "Flow of Funds" report has become a more challenging endeavor. Yet one might be tempted to glance at the broad Credit aggregates and find little cause for delving into the detail. Total Credit Market Debt (Non-financial and Financial) increased $755 billion during the quarter (7.1% annualized), down from Q2's $820 billion (7.8%) and little changed from Q3 2005's $760 billion. Over the past year, Total Credit Market Debt increased $3.526 Trillion, or 8.8%. For perspective, Total Credit Market Borrowings increased $2.352 Trillion during 2002, $2.729 Trillion in 2003, $3.003 Trillion in 2004, and $3.436 Trillion in 2005.

Total Non-Financial Credit expanded at a 6.7% seasonally-adjusted annual rate (SAAR), unchanged from Q2 and down from Q1's 9.5%. Importantly, however - and this pertains to the entire "Z.1" analysis - Credit and financial flow data trends should be contemplated in the context of the marked deceleration in nominal GDP growth over the past three quarters - from 9.0% to 5.9% to the third quarter's 4.0%. And does the Flow of Funds provide insight to further our understanding of the paradox between reduced borrowings in the real economy and heightened liquidity in financial markets at home and abroad?

With home mortgage debt growth decelerating, Total Household Borrowings slowed to 6.8% SAAR, down from Q2's 9.2%, Q1's 9.7%, and Q4 2005's 11.6%. Total Business Borrowings slipped somewhat to a 7.7% pace, down from Q2's 8.4%, Q1's 9.6% and Q4 2005's 7.7%. Bucking the trend, State & Local Government Borrowings jumped to a 9.3% rate, up from Q2's 6.6%, Q1's 3.5%, and Q4 2005's 9.7%. Enjoying booming receipts, Federal Government Borrowings nonetheless bounced back somewhat to a moderate 3.3% rate, reversing Q2's negative 2.4% but below Q1's 11.3% and Q4 2005's 8.0%.

Continuing a prominent Q2 "Flow of Funds" development, the more intriguing aspect of Q3 data is buried in the nature of Financial Sphere ballooning. Don't be fooled by the sharp slowdown in Credit market borrowings from the Fed's aggregate "Domestic Financial Sectors" - which slowed to 5.6% from Q2's 10.5% and Q1's 8.6% pace. The contraction of GSE balance sheets played a role during the quarter. Additionally, key funding sources for the unrelenting Financial Sphere expansion are not captured within "Credit Market Borrowings."

I posit that ballooning securities finance (in particular, speculative securities leveraging along with booming M&A) has developed into a key force in ongoing system liquidity creation. Cutting to the chase a bit, "Fed Funds & Repos" expanded at a 26.9% rate during the quarter and "Funding Corps" grew 25% annualized. Broker/Dealer Assets ballooned at a blistering 28% pace during the quarter, expanding balance sheets much more rapidly than the Banks ($168.3bn vs. $39.5bn). Why the need for such aggressive expansion in the face of a slowing economy?

The impetus to Financial Sphere expansion provided by the U.S. housing slowdown and resulting economic moderation has been the major financial development of 2006. Or, stated differently, Wall Street has been eagerly prepared to take full advantage of the conclusion of a "tightening" cycle that never approached imposing actual financial tightening. The "Flow of Funds" clearly captures this major inflation of securities market-based Credit instruments.

During the first three quarters of the year, Broker/Dealer Assets expanded $427 billion, or 27% annualized, to $2.57 Trillion. For comparison, assets expanded on average $170 billion during the first half of the decade. Broker/Dealer Assets have now expanded $750 billion, or 45%, in just the past two years. During Q3, Broker/Deader Financial Assets expanded $601 billion SAAR. Miscellaneous Assets ballooned $432 billion SAAR to $1.539 Trillion (up 54% y-o-y). Holdings of "Credit Market Instruments" expanded $192 billion SAAR during the quarter (to $546bn), the largest increase since Q4 2005. By major category, Treasuries increased SAAR $96 billion, Agency/GSE MBS $23 billion, and Corporate Bonds $65 billion.

Financing the historic Broker/Dealer Bubble, "Security Repos (net)" expanded $509 billion SAAR and Securities Credit from Banks $101 billion SAAR during the quarter. Year-to-date, the Liability "Repos" has expanded at a 41% rate to $965 billion and the Liability "Security Credit" 21.5% to $282 billion. For comparison, so far this year Broker/Dealer Credit Market Bond borrowings have increased $11.6 billion to $74 billion.

At the epicenter of securities finance, "Funding Corporations" ("Funding subsidiaries, nonbank financial holding companies, and custodial accounts for reinvested collateral of securities lending operations") expanded assets $473 billion SAAR during the quarter, or 25% annualized, to $2.012 Trillion. Year-to-date, Funding Corps have grown at a 13.8% rate. Funding Corp Assets have ballooned almost a third in seven quarters. Their largest Asset - "Investment in Broker and Dealers" - expanded $303 billion SAAR during the quarter to $902 billion (up 21% annualized y-t-d). On the "Funding Corp" Liability side, "Securities Loaned (Net)" expanded $336 billion SAAR during the quarter. Year-to-date, "Securities Loaned" has ballooned at a 36% rate to $1.214 Trillion. Notably, the Securities Loaned Liability has increased 59% since December 2004. Also on the Liability side, "Open Market Paper" (largely commercial paper) expanded $210 billion SAAR during the quarter. Year-to-date, Open Market Paper has grown at a 19% rate to $563 billion.

The Fed's category "Federal Funds and Securities Repurchase Agreements" expanded $606 billion SAAR during the third quarter ($509 billion SAAR lent to the Broker/Dealers). Year-to-date, Fed Funds & Repo has ballooned $366 billion, or 24% annualized, to $2.371 Trillion, with a two-year gain of 42%. On the Liability side (the entities holding these Credit instruments), owed to Money Market Mutual Funds increased $266 billion SAAR during the quarter (to $368bn) and Rest of World $144 billion SAAR (to $805bn). ROW Fund Funds & Repo holdings have expanded at a 17% rate y-t-d.

Bubbling Securities Finance is certainly taking up any slack created from slowing mortgage debt growth. Total Mortgage Debt (TMD) expanded at an 8.4% rate to $13.033 Trillion. TMD was up $1.282 Trillion y-o-y, or 10.9%. For comparison, TMD increased $562 billion during 2000, $690 billion in 2001, $881 billion in 2002, $1.007 Trillion in 2003, $1.304 Trillion in 2004, and $1.468 Trillion last year, after annual growth averaged $269 billion during the nineties. During the third quarter, Home Mortgage Borrowings slowed to a 7.4% rate (to $10.029 Trillion), reducing y-o-y growth to 10.4%. At 13.4% annualized, Commercial Mortgage debt growth was little changed from Q2, with y-o-y growth of 14.8% (to $2.130 Trillion).

Impacted by slower mortgage borrowings, the booming Asset-Backed Securities (ABS) marketplace saw growth reduced to a still robust 10.6% annualized during the quarter to $3.323 Trillion, down from Q2's 12.7% growth rate. ABS has expanded $468 billion, or 16.4%, over the past year and $1.011 Trillion, or 42%, during the past two years. GSE balance sheets contracted at a 3.7% rate during the quarter to $2.837 Trillion, a reversal from Q2's 7.1% growth rate (GSE assets up 3% y-o-y). Outstanding GSE MBS expanded at an 8.3% rate during the quarter to $3.892 Trillion (up 7.6% y-o-y).

Certainly playing a prominent role in the intermediation of rapidly inflating "repo" and "Fed funds" Credit instruments (financing the Securities Finance Bubble), Money Market Funds (MMF) expanded at a 19% rate during the quarter to $2.167 Trillion. On a seasonally-adjusted and annualized basis, MMF assets increased $439 billion during the quarter, with Security Repos up $161 billion and Open Market Paper up $266 billion. MMF assets were up $290 billion, or 15.4%, over the past year.

Elsewhere, REIT liabilities expanded at a 9.2% to $607 billion (up 11% y-o-y). Savings Institution assets expanded at a 14.5% rate to $1.833 Trillion (up 9.8% y-o-y). Finance Company assets expanded at a 3.2% rate to $1.872 Trillion (up 5.3% y-o-y). And Credit Union assets grew at a 4.0% pace to $711 billion (up 3.7% y-o-y).

Bank balance sheet growth was sharply reduced during the quarter, impacted by the housing slowdown as well as the likely increased securitizing and selling of various types of loans (some into CDOs and other "structured finance" vehicles). Bank Mortgages expanded at a 6.7% rate, down from Q2's 12.7% and Q1's 8.8% pace. MBS holdings dropped $62 billion during the quarter, reducing y-o-y growth in MBS and Treasuries to 2.1%. Contracting Securities Credit reduced overall Bank Credit growth to 3.7% during the quarter, although keep in mind that many of the securities unloaded by the Banks ended up on the balance sheets of the Broker/Dealers and their hedge fund clients.

The "Rest of World" (ROW) continues to "recycle" extraordinary liquidity into the top-tier U.S. securities markets. ROW holdings of U.S. financial assets increased $343 billion during the quarter, or 11.8%, to $11.946 Trillion. On a seasonally-adjusted and annualized basis, ROW holdings ballooned $1.439 Trillion. In nominal dollars, Treasury holdings increased $41 billion to $2.070 Trillion, Agencies $53 billion to $1.131 Trillion, and Corporate Bonds $86 billion to $2.597 Trillion. Better illustrating the scope of foreign purchases in key markets during the quarter, on a seasonally-adjusted and annualized basis Treasury holdings increased $163 billion, Agency/MBS $213 billion, and Corporate Bonds $344 billion. Over the past year, holdings of Agency/MBS have increased $247 billion (28%) to $1.131 Trillion and Corporate Bonds $301 billion (13.1%) to $2.597 Trillion. Little wonder there has been such downward pressure on market yields (no "conundrum"). Over the same period, Foreign Direct Investment was up $111 billion (6.5%) to $1.820 Trillion.

The Household Balance Sheet continues to provide insight into consumer resiliency. Household Net Worth increased $775 billion during the quarter, up sharply from Q2's $27 billion rise. Total Household Assets inflated $1.044 Trillion (6.3% annualized) during the quarter to $67.058 Trillion, while Liabilities increased $268 billion (8.4% ann.) to $12.995 Trillion. On the Asset side, Financial Assets increased $747 billion (7.5% ann.), with Deposits rising $158 billion (10.1% ann.). Household Real Estate increased $242 billion, or 4.4% annualized, to $22.42 Trillion. Over the past year, Household Assets inflated $4.608 Trillion, or 7.4%. Real Estate increased $1.781 Trillion (8.6%) and Financial Assets $2.616 Trillion (6.9%). Household Liabilities expanded "only" $1.106 Trillion, or 9.3%, over the past year. Household Net Worth, then, inflated $3.502 Trillion, or 6.9%, over the past year to $54.06 Trillion. Net Worth has inflated 40% in four years.

I certainly see strong support from the Flow of Funds data for my view that Financial Sphere ballooning has this year assumed a prominent role in sustaining system liquidity excesses. Ultra-loose financial conditions can be recognized in the huge expansion in money market instruments (i.e. "repos," "Fed funds," and commercial paper), intermediation through money market funds, and the ballooning of Wall Street balance sheets. The resulting liquidity deluge has inflated securities prices at home and abroad, in the process fostering self-reinforcing global M&A and stock market booms. Global liquidity excess is fueled by the confluence of massive U.S. Current Account Deficits, enormous outgoing speculative flows from the U.S., and unchecked domestic Credit excess around the world.

Traditionally, economists examine only the expansion of Non-Financial debt; the thought being that taking into account financial sector borrowings would result in double-counting. Well, there is certainly an issue with double-counting, but to these days ignore the Credit creation associated with financial system leveraging is to remain oblivious to history's greatest liquidity engine. For years, Credit Bubble lending excess (i.e. mortgages, telecom and corporate debt, Treasuries, etc.) has created system liquidity abundance. Of late, the more aggressive speculative leveraging of this edifice of tens of Trillions of securities and loans has provided Wall Street with another profit and liquidity-creating windfall. Recently, I've referred to the Global Corporate Debt Bubble. Global Securities and Corporate Debt Bubbles would be more explanatory.


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