Former U.S. Treasury secretary Paul O'Neill commented that the "Fed put the punch back into the punchbowl." For the week, the Dow and S&P500 gained 2.8%, increasing y-t-d gains to 10.9% and 7.6%. The Morgan Stanley Cyclical index jumped 4.3% (up 18.2% y-t-d), and the Morgan Stanley Consumer index gained 3.1% (up 6.6%). The Utilities rose 2.3% (up 9.7%), and the Transports added 0.6% (up 5.9%). The small cap Russell 2000 jumped 3.1% (up 3.2%), and the S&P400 Mid-Cap index gained 2.2% (up 9.6%). Technology stocks added to strong already gains. The NASDAQ100 rose 2.4% (up 16.7%), and the Morgan Stanley High Tech index gained 2.6% (up 16.7%). The Semiconductors increased 2.9% (up 7.1%). The Street.com Internet advanced 2.0% (up 15.7%), and the NASDAQ Telecommunications index jumped 3.3% (up 19.9%). The Broker/Dealers (down 4.0%) and Banks (down 7.7%) both gained 2.3%. With Bullion rising $23.90, the HUI Gold index surged 9.4% (up 18.2%).

The Fed threw the yield curve for a loop. Three-month T-bill rates sank 23 bps this week to 3.76%. Two-year U.S. government yields were unchanged at 4.04%, while five-year yields rose 12 bps to 4.29%. Ten-year Treasury yields jumped 16 bps to 4.62%. Long-bond yields ended the week 16.5 bps higher at 4.885%. The 2yr/10yr spread ended the week at 58 bps, the high since May '05. The implied yield on 3-month December '07 Eurodollars fell 15 bps to 4.74%. Benchmark Fannie Mae MBS yields rose 5 bps to 5.95%, this week meaningfully outperforming Treasuries. The spread on Fannie's 5% 2017 note narrowed 3 to 46, and the spread on Freddie's 5% 2017 note narrowed 3.5 to 45.6. The 10-year dollar swap spread declined 3 to 64.3. Corporate bond spreads narrowed. The spread on a junk index ended the week 6 bps narrower.

Investment grade debt issuers included Tyco $2.05bn, Marathon Oil $1.5bn, Suncor $1.15bn, Rockies Express $600 million, Leucadia National $500 million, Southwest Air $500 million, Weyerhaeuser $450 million, Liberty Properties $300 million, Avery Dennison $250 million, and San Diego G&E $250 million.

Junk issuers included RH Donnelley $1.0bn, Compucom Systems $210 million and Baseline Oil $165 million.

Convert issuers included Powerwave Technologies $150 million and Equinix $350 million.

Foreign dollar bond issuance included Barclays $2.0bn, Glitnir Bank $1.0bn, Rede Empresas Energia $575 million, and Canadian National Railroad $550 million.

German 10-year bund yields surged 19 bps to 4.36%, as the DAX equities index jumped 4.0% (up 18.2% y-t-d). Japanese 10-year "JGB" yields rose 13.5 bps to 1.675%. The Nikkei 225 rose 3.1% (down 5.3% y-t-d). Emerging debt markets were mixed to higher, while equities went higher and higher. Brazil's benchmark dollar bond yields fell 10 bps to 5.85%. Brazil's Bovespa equities index burst 5.7% higher (up 30% y-t-d). The Mexican Bolsa gained 1.6% (up 15.6% y-t-d). Mexico's 10-year $ yields rose 7 bps to 5.56%. Russia's RTS equities index jumped 4.3% (up 5.4% y-t-d). India's Sensex equities index surged 6.2% (up 20.1% y-t-d). China's Shanghai Composite index added 2.7% to close at yet another record high (up 104% y-t-d and 213% over the past year).

Freddie Mac posted 30-year fixed mortgage rates rose 3 bps this week to 6.34% (down 6bps y-o-y). Fifteen-year fixed rates added one basis point to 5.98% (down 8bps y-o-y). One-year adjustable rates dipped one basis point to 5.65% (up 11bps y-o-y).

Bank Credit increased $11.4bn (week of 9/12) to a record $8.924 TN. After a seven-week surge of $284bn, Bank Credit has now increased $628bn y-t-d, or a rate of 10.6%. For the week, Securities Credit surged $26.9bn. Loans & Leases dropped $15.5bn to $6.528 TN (7-wk gain of $200bn). C&I loans gained $12.15bn and Real Estate loans added $0.2bn. Consumer loans fell $10.0bn. Securities loans were little changed, while Other loans dropped $17.1bn. On the liability side, (previous M3) Large Time Deposits supped $23.9bn.

M2 (narrow) "money" fell $17.3bn to $7.349 TN (week of 9/10). Narrow "money" has expanded $305bn y-t-d, or 6.1% annualized, and $473bn, or 6.9%, over the past year. For the week, Currency added $0.3bn, while Demand & Checkable Deposits sank $49bn. Savings Deposits jumped $34.2bn, and Small Denominated Deposits added $1.1bn. Retail Money Fund assets declined $3.7bn.

Total Money Market Fund Assets (from Invest. Co Inst) dipped $3.1bn last week to $2.825 TN. Money Fund Assets have increased $443bn y-t-d, a 25.5% rate, and $600bn over 52 weeks, or 26.9%.

Total CP dropped another $48bn to $1.869 TN, raising the six-week decline to $354.4bn. Asset-backed CP dropped another $15.9bn (6-wk drop of $244.5bn) to $928.9bn. Year-to-date, total CP is now down $105.2bn, with ABCP declining $155bn. Over the past year, Total CP is now down $13bn, or 0.7%.

Asset-backed Securities (ABS) issuance increased modesly to $7.2bn this week. Year-to-date total US ABS issuance of $453bn (tallied by JPMorgan) is now running 29% behind comparable 2006. At $209bn, y-t-d Home Equity ABS sales are 49% below last year's pace. Year-to-date US CDO issuance of $260 billion is running 5% ahead of 2006 sales.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 9/19) rose $6.2bn to $1.987 TN. "Custody holdings" were up $235bn y-t-d (18.4% annualized) and $314bn during the past year, or 18.8%. Federal Reserve Credit last week declined $4.2bn to $853bn. Fed Credit has increased $0.8bn y-t-d and $24.1bn over the past year (2.9%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $933bn y-t-d (26.5% annualized) and $1.153 TN y-o-y (25.1%) to $5.743 TN.

Currency Watch:

The dollar index sank 1.3% to 78.60. On the upside, the New Zealand dollar increased 5.3%, the Australian dollar 4.0%, the Brazilian real 2.8%, the South African rand 3.1%, the Canadian dollar 2.7%, and the Swedish krona 2.7%. On the downside, the Japanese yen declined 0.3%. The Euro gained 1.6% to a record high.

Commodities Watch:

For the week, Gold jumped 3.4% to $731.5 and Silver 7.2% to $13.62. December Copper rose 5.9%. November crude ended the week at a record $81.62, up $3.53 on the week. October gasoline gained 3.5%, while October Natural Gas declined 3.2%. December Wheat was little changed. For the week, the CRB index surged 3.8% (up 8.4% y-t-d), and the Goldman Sachs Commodities Index (GSCI) jumped 3.5% (up 25.5% y-t-d).

Japan Watch:

September 18 - Bloomberg (Toru Fujioka): "Japanese households' assets rose to a record in the three months ended June 30, as individuals earned higher returns on stocks, mutual funds and bonds. The value of households' assets rose 2.9% to 1,555 trillion yen ($13.5 trillion) from a year earlier, the Bank of Japan said..."

September 19 - Bloomberg (Kathleen Chu): "Land prices in Japan's three largest metropolitan areas rose for a second-straight year, and nationwide commercial land prices rose for the first time in 16 years as the country's property market continued its rebound. The value of property in the Tokyo, Osaka and Nagoya regions gained 5.1% on average for the year ended June 30..."

China Watch:

September 19 - Market News International: "China's retail sales are expected to rise 15% to 8.8 trln yuan in 2007, the Ministry of Commerce's department of market regulation said... In the first eight months, retail sales were up 15.7%..."

India Watch:

September 21 - Bloomberg (Cherian Thomas): "India may cut cash held by lenders for the fourth time this year as currency sales by the central bank aimed at curbing rupee gains flood the economy with excess money, Credit Suisse AG and Nomura Securities Co. said. India's currency has strengthened beyond 40 per dollar for the first time in nine years amid unprecedented overseas investment in local shares. The central bank has injected rupees worth $43.1 billion in the nine months to July, almost three times the amount in previous nine months."

Asia Watch:

September 21 - Bloomberg (Perris Lee): "Taiwan's export orders grew at a slower pace in August as a housing recession eroded demand from the U.S., the island's second-biggest overseas market. Orders for shipment overseas rose 16.32% from a year earlier, slowing from July's 23.49% gain..."

September 21 - Bloomberg (Karl Lester M. Yap): "Philippine money supply grew less than 20% in August, central bank Deputy Governor Diwa Guinigundo told reporters..."

Unbalanced Global Economy Watch:

September 18 - Bloomberg (David M. Levitt and Bryan Keogh): "The world economy 'is probably at its scariest point since the Depression' as fallout from the U.S. subprime mortgage crisis crimps access to credit, said Ethan Penner, a pioneer of the $600 billion commercial mortgage-backed securities market in the early 1990s. 'We're probably at the closest point to a big meltdown, a depression-type meltdown than we have been in our lives,' said Penner...now a principal at real estate fund management firm Lubert-Adler Partners LP... The U.S. housing market is an 'unmitigated disaster'... As foreclosures rise, lenders will try to sell the properties they acquire at depressed prices, dragging the market down further, he said."

September 19 - The Wall Street Journal Europe: "U.K. housing boom has been a long time coming, but it has finally arrived. The 3% August drop in the average house price, as reported by property Web site Rightmove, certifies the beginning of the new era. The end comes when prices are too high by any measure... The Bank of England tried to prick the bubble with rhetoric and higher interest rates. But its tactics proved much less potent than the credit crunch."

September 19 - Bloomberg (Fergal O'Brien): "Europe's manufacturing and service industries grew at the slowest pace in two years this month after paralysis in the credit markets hurt banks, adding to evidence economic growth is waning."

Latin America Watch:

September 19 - Dow Jones (Anthony Harrup): "First it was tortillas, then milk, and now Mexican bread prices are going up, corroborating the central bank's persistent warnings about food prices threatening its inflation outlook. Mexico's baking industry confirmed this week that it plans to raise bread prices by 15% to 17% on average to recoup rising costs of wheat flour and other raw materials. Antonio Arias Ordonez, president of the Mexican Bakeries Industry Chamber, said he expects all of the country's roughly 26,500 bread shops to raise their prices. 'It would be unusual if they didn't after raw materials costs have risen between 55% and 65%' Arias said... Apart from flour, prices of margarine, eggs and sugar, have also been rising, he added."

Bubble Economy Watch:

September 18 - Bloomberg (Carlyn Kolker): "U.S. companies increased total compensation for their chief in-house lawyers by 14% in 2007, according to a survey by legal consultant Altman Weil Inc., which cited competition for legal talent... Median total pay for chief legal officers was $457,000, according to the survey... Salaries rose 5.8% to $300,000, and bonuses were up 43% to $157,000. 'This may reflect a need to counter the dramatic increases in law firm starting salaries as general counsel compete with law firms for talent,' Altman Weil consultant James Wilber said... Several New York-based law firms raised pay for first-year attorneys to $160,000 this year."

Central Banker Watch:

September 18 - Bloomberg (Bob Willis and Tom Keene): "Conrad DeQuadros, senior economist at Bear Stearns & Co. in New York, comments on the Federal Reserve's decision yesterday to cut its benchmark interest rate to 4.75% from 5.25%. In a note to clients, he and Bear Stearns chief U.S. economist John Ryding called yesterday a 'black day' for the Fed. Dequadros spoke in an interview... On the language in his note: 'It is strong language. For the Fed to cut rates aggressively while citing that inflation risks remain, that risks the Fed's inflation fighting credibility... There are also issues of credibility about Fed communications in that there was no signal from Fed officials that such a move was coming... The direction we seem to be on in terms of adding liquidity to a financial system that already has plenty of liquidity risks putting us in a scenario in which the Fed might have to constrain monetary expansion very drastically at some point down the road."

September 19 - The Wall Street Journal (Greg Ip ): "Federal Reserve Chairman Ben Bernanke moved aggressively to stop the spreading credit crunch from sinking the nation's economy with a surprising half-percentage-point cut in interest rates, casting aside for now worries about appearing to bail out investors. The cut, which exceeded the quarter-point reduction most economists had expected, signals that Mr. Bernanke, fearing broad damage from the market turmoil that erupted a month ago, preferred to risk doing too much rather than too little. The move came amid a sizable drop in home sales, construction and prices that could send mortgage defaults higher and damp consumer spending. With yesterday's move, Mr. Bernanke may have shown himself closer in style and tactics to predecessor Alan Greenspan than some market watchers had suspected. That carries risks: Critics may start referring to the 'Bernanke put,' as they once spoke of the 'Greenspan put' under the former Fed chairman..."

September 18 - Bloomberg (Christian Vits): "European Central Bank council member Axel Weber said he expects stronger economic growth and rising oil prices to stoke inflation. 'We have to expect somewhat higher inflation rates for the rest of the year,' Weber, who also heads Germany's Bundesbank, said..."

September 1- Market News International (Steven K. Beckner): "There are many interesting aspects of former Federal Reserve Chairman Alan Greenspan's just-released book, but perhaps the most important are his warnings about inflation...from a Fed watchers' standpoint, Greenspan's premonitions about inflation and long-term interest rates are the most timely... Greenspan ascribes much of the Fed's ability to get inflation under control in recent years to globalization. 'The continuing acceleration of the flow of workers to competitive markets during the past decade has been a potent disinflationary force...' This disinflation has in turn helped hold down long-term interest rates... But he writes that 'the rate of flow of workers to competitive labor markets will eventually slow, and as a result, disinflationary pressures should start to lift. China's wage-rate growth should mount, as should its rate of inflation.' Chinese export prices...will rise further, he predicts. The result will be 'a pickup of price inflation and wage growth in the United States', writes Greenspan, adding, 'the burden of managing this shift will fall on the Federal Reserve.' 'How significant -- and how corrosive - these price pressures will become for the American economy will depend in large part on the Fed's ability to respond' he writes, adding, 'The degree of monetary restraint required to contain any given rate of inflation will increase'"

September 19 - Bloomberg (Pimm Fox and Kevin Carmichael): "Paul O'Neill, a former U.S. Treasury secretary and now a special adviser to Blackstone Group LP, comments on the Federal Reserve's decision yesterday to lower interest rates... 'The markets were very fearful of the liquidity crunch. Markets basically stopped trading. They were reassured by the chairman's action yesterday. One might say Ben put the punch back in the punchbowl. There was nothing in the punchbowl. He succeeded in reassuring the markets that the Fed was not going to let this linger on. I think that's what we needed.'"

California Watch:

September 21 - Bloomberg (William Selway): "A majority of Californians expect the economy to worsen in the most populous U.S. state over the next year as housing sales plunge and more residents lose their homes to foreclosure, the results of a poll released today show. Fifty-nine percent of adults expect 'bad times' financially over the next 12 months, a jump of 10 percentage points since June..."

GSE Watch:

September 18 - Bloomberg (James Tyson): "Federal Reserve Chairman Ben S. Bernanke opposed a push to allow Fannie Mae and Freddie Mac to buy mortgages higher than $417,000, saying it may undermine efforts to strengthen regulation of the two largest U.S. mortgage finance companies. A proposal in Congress to increase the limit 'would be ill-advised if it has the practical effect of reducing the incentives to achieve meaningful' regulatory tightening over the companies, Bernanke said... [Representative] Frank and other Democrats, seeking to reverse the biggest housing market slump in 16 years, have called on the Bush administration to allow Fannie Mae and Freddie Mac to buy bigger mortgages and expand their $1.5 trillion investment portfolios. The companies' regulator announced today it will allow the companies to annually increase their purchases of home loans and mortgage bonds by 2%. Bernanke in the letter written two days ago said... 'Both the size and composition of the portfolios should be tied to reforms that both reduce the systemic risks posed by the portfolios and also clarify the public purpose,' Bernanke said..."

Mortgage Finance Bust Watch:

September 18 - Marketwatch (Robert Schroeder): "Reaching out to hard-hit borrowers in the subprime-mortgage market, the House...passed a bill that lowers down payments for borrowers, raises loan limits and boosts funds for housing counseling. Passed by a vote of 348 to 72, the bill reforms the Federal Housing Administration and is the latest lifeline thrown to borrowers from Washington... About two million loans are expected to reset to higher rates in the next two years, with defaults expected to follow... The bill directs up to $300 million a year into an affordable housing fund. A motion offered by Rep. Jeb Hensarling, R-Texas, to kill the fund was rejected... Lawmakers also passed an amendment to the bill offered by [Representative] Frank that would raise the agency's loan limit from its current $417,000 to as much as $729,750. 'Such an increase would ensure that FHA is a viable option for borrowers who have payment option and interest-only adjustable rate mortgages (ARMs), which will be resetting in the next few years," said Stanford Group Company analyst Jaret Seiberg."

Foreclosure Watch:

September 18 - Associated Press (Alex Veiga): "The number of foreclosure filings reported in the U.S. last month more than doubled versus August 2006 and jumped 36% from July, a trend that signals many homeowners are increasingly unable to make timely payments on their mortgages or sell their homes amid a national housing slump. A total of 243,947 foreclosure filings were reported in August, up 115% from 113,300 in the same month a year ago...RealtyTrac Inc. said... 'The jump in foreclosure filings this month might be the beginning of the next wave of increased foreclosure activity, as a large number of subprime adjustable rate loans are beginning to reset now,' RealtyTrac Chief Executive James J. Saccacio said... The latest figures also reflect an increase in the number of homes going into foreclosure that are not being picked up in estate sales and are ending up going back to lenders. The number of bank repossessions jumped to 42,789 in August, compared with 20,116 a year earlier, the RealtyTrac said. In July, there were 26,842 bank repossessions. Nevada, California and Florida had the highest foreclosure rates in the country last month, the firm said... California's foreclosure rate was one filing for every 224 households. The state reported the most foreclosure filings of any single state with 57,875, up 48% from July and an increase of more than 300% from August 2006."

September 19 - Bloomberg (Bob Ivry): "As many as half of the 450,000 subprime borrowers whose mortgage payments increase in the next three months may lose their homes because they can't sell, refinance or qualify for help from the U.S. government. 'Short of the cavalry riding in over the hill, a lot of these people are just stuck,' said Christopher Cagan, director of research and analytics at...First American CoreLogic... The number of borrowers whose mortgage payments jump in the next three months will be the second-highest ever for a quarter, according to Credit Suisse... Twenty-seven percent have already missed a payment, said First American LoanPerformance, which owns the largest database of U.S. mortgages. That makes them ineligible for the Federal Housing Administration bailout proposed last month by President George W. Bush."

MBS/ABS/CDO/CP/Money Funds and Derivatives Watch:

September 18 - Bloomberg (Jody Shenn): "Securities backed by prime U.S. jumbo mortgages may be riskier than investors think because almost half of the underlying loans are from California, where home prices may again collapse, according to Barclays PLC. California accounts for 45% of jumbo mortgages in securities sold last year, up from 35% in 1989, Barclays mortgage-bond analysts wrote... Following a housing boom, home prices in California declined by 12.5% between 1991 and 1995. Losses after foreclosures on jumbo loans securitized in 1989 rose to 3%, which would be enough to cause many current investment-grade bonds to default. 'The current housing environment in California appears similar to the 1990s,' wrote the...analysts led by Ajay Rajadhyaksha. 'Many investors believe that jumbo credit is sound. We think that this sense of security is misplaced.'"

Real Estate Bubbles Watch:

September 18 - Bloomberg (Dan Levy): "San Franciscans soon may have to crane their necks back a bit farther to gaze up at the city's tallest buildings. City officials are pushing for construction of two office and residential towers of 1,200 feet or more - at least 80 stories. They would dwarf the Transamerica Pyramid, which at 853 feet has been the tallest building in San Francisco since 1972. The new structures would challenge the 1,250-foot height of the Empire State Building in New York, the second-tallest U.S. building. It's 'imperative' for San Francisco to keep pace as super-tall towers spring up around the globe, Mayor Gavin Newsom said... 'Tall buildings are symbols of cities that don't want to be left behind in a competitive world,' architect Daniel Libeskind, who worked on designs for towers to replace Manhattan's World Trade Center, said..."

September 17 - Bloomberg (Peter Woodifield): "Construction of the London office tower dubbed 'the Shard' may be delayed because of an increase in borrowing costs, according to the developer of the building that would be the U.K.'s tallest. Talks about financing the project 'have, unfortunately, been affected by the recent adverse credit markets,' said Sten Mortstedt, chairman of CLS Holdings Plc... Work on the 72-story building, which will cost about 400 million pounds ($799 million), is due to start later this year."

Speculator Watch:

September 18 - Bloomberg (Jesse Westbrook and Jenny Strasburg): "The U.S. Securities and Exchange Commission is examining hedge funds for signs of insider trading, demanding information about relationships between managers, employees, family members and public companies. SEC officials told hedge funds to list clients and workers who serve as officers or directors of publicly traded companies, along with the names of any relatives who hold such posts, according to a 27-page letter to industry executives... The SEC confirmed its authenticity."

Q2 2007 Flow of Funds:

Considering third-quarter financial market developments, it is tempting to view Q2 Credit analysis as somewhat less than timely and relevant. Yet the data do provide evidence of worsening unstable dynamics - in particular, an energized Financial Sphere expanding at breakneck speed, easily outdistancing the flagging Economic Sphere. Highlights for the quarter included double-digit growth rates for both Commercial Bank and Broker/Dealer balance sheets. The ABS market continued its streak of double-digit growth, and Agency MBS posted back-to-back quarters of double-digit expansion. The Money Market Complex expanded at an almost 17% rate. Rest of World (ROW) holdings of U.S. Assets expanded double-digit rates as well.

Overall, Total Net Borrowing in the Credit Markets increased at a SAAR (seasonally-adjusted and annualized rate) $3.757 TN during Q2 to $46.573 TN. This was down only slightly from Q1's SAAR $3.784 TN, and, for perspective, compares to 2006's growth of $3.825 TN, 2005's $3.380 TN, 2004's $3.085 TN, 2003's $2.767 TN, and 2002's $2.365 TN. Notably, Corporate borrowings expanded at a 10.7% rate during the quarter, State & Local governments 11.9%, and the Financial Sector 9.8%. Financial sector borrowings built on Q1's brisk pace (9.7%) to the strongest rate of expansion in a year. And while recent Credit market turmoil has imposed borrowing restraint, it is worth noting that first-half corporate debt growth was at the fastest pace since 1999.

Total Non-Financial Debt expanded at a SAAR $2.080 TN (to $29.869TN), down somewhat from Q1's $2265 TN. By sector, Household debt expanded SAAR $926bn (vs. Q1's $908bn) to $13.292 TN; Non-Financial Corporations SAAR $626bn (vs. Q1's $520bn) to $6.050 TN; Non-Farm Non-Corporate SAAR $348bn (vs. Q1's 267bn) to $3.260 TN; Farm Business SAAR $5.1bn (vs. $20.6bn) to $210bn; and State & Local Govt. SAAR $246bn (vs. $224bn) to $2.130 TN. Accounting for more than all of Q2's decline in Non-Financial Debt Growth, Federal Government borrowings actually contracted SAAR $71bn, compared to Q1's expansion of SAAR $326bn. Federal government fiscal improvement will be fleeting.

Continuing a trend that became quite pronounced last year, near double-digit financial sector growth far exceeds that of the real economy. Financial Sector Credit Market Borrowings (FCMB) increased SAAR $1.423 TN (up from Q1's $1.377 TN) to $14.866 TN. For perspective, FCMB expanded $1.282 TN during 2006, $1.092 TN in 2005, $980bn in 2004, $1.053 TN in 2003, and $869bn in 2002. It is illuminating to note the type of Credit instruments that financed the financial sector expansion. During the quarter, "Open Market Paper" increased SAAR $360bn, "GSE Issues" SAAR $99bn, Agency-and GSE-backed securities SAAR $544bn, Corporate bonds SAAR $365bn, Bank Loans SAAR $47bn, and (bank liabilities) Mortgages SAAR $8.2bn. It will likely be some time before "Open Market Paper" and Corporate bonds expand at such rates.

The Wall Street Bubble was alive and well during Q2. The Broker/Dealers expanded Assets at SAAR $703bn to $3.155 TN. Broker/Dealer Assets inflated $413.1bn (nominal) during the first half, or 30.1% annualized. This expansion was second only to 2006's full-year $615bn growth. For perspective, Broker/Dealer Assets increased $282bn during 2005, $232 in 2004, and $278 in 2003 - and actually contracted $130bn during 2002. Examining the nature of Asset growth during the quarter, Corp & Foreign bonds increased SAAR $84bn, Securities Credit SAAR $219bn, and "Miscellaneous" SAAR $621bn. Treasury holdings declined SAAR $157bn and Agency/GSE MBS fell SAAR $101bn. On the Liability Side, Miscellaneous Liabilities increased SAAR $525bn, Securities Credit SAAR $95bn, and Trade Payables $55bn.

Wall Street "structured finance" enjoyed a booming and, perhaps, foretelling Q2. GSE Assets expanded SAAR $176bn (to $2.923TN), the strongest growth in a year. Still, GSE assets were up only 1.1% y-o-y. Agency MBS surged SAAR $544bn, up from Q1's $499bn and the year earlier $300bn. Agency MBS expanded at a 12.3% rate during the quarter, with one-year gains of 10.8%. Asset-Backed Securities expanded SAAR $545bn (to $4.295 TN), down only modestly from Q1's $574bn. And despite the slowest quarter in some time, the ABS market still enjoyed a 13.3% growth rate for the quarter and 18.1% growth over the past year. The ABS market has expanded 63% during the past 10 quarters, extraordinary growth that hit the wall with a thud with the homecoming of market tumult in Q3.

Interestingly, Total Mortgage Debt (TMD) expanded SAAR $1.167 TN (to $13.982 TN), up from Q1's SAAR $1.087 TN. TMD actually expanded at a robust 9.0% rate, the largest expansion since Q3 2006 - suggesting that ultra-easy Credit Conditions endured outside of subprime. Even Home Mortgage debt growth accelerated, rising to a 7.7% rate from Q1's 7.3%. Meanwhile, the Commercial Mortgage lending boom went to "blow-off" extremes - expanding at a 15.6% pace (vs. Q1's 10.1%). For the quarter, Home Mortgage lending expanded SAAR $756bn to $10.750 TN and Commercial Mortgage a record SAAR $344bn to $2.344 TN. Total Mortgage debt has expanded 9.2% over the past year and 24% over two years, with Commercial mortgage debt up 13.9% y-o-y and 31%. It will be fascinating to learn how dramatically mortgage debt growth slowed during Q3. Credit restraint hit all sectors.

Quite possibly, Q3 will see record banking sector asset growth, both building on Q2 momentum and taking up the slack created by the Breakdown of Wall Street Risk Intermediation. During the second quarter, Commercial Banking Assets expanded SAAR $1.037 TN to $10.455 TN. For comparison, Bank Assets grew $897bn during 2006, $763bn in 2005, $762bn in 2004, $495bn in 2003 and $477bn in 2002. On a percentage basis, Q2 experienced Bank Asset growth of 10.5%, with Loans up 8.9%. Over the past year, Bank Loans have expanded 9.0%, with a two-year gain of 22.9%. Bank holdings of Mortgage loans expanded at a 9.9% rate during the quarter (to $3.462TN), with one-year growth of 10.5%. Corporate Bond holdings jumped $44.4bn (22.1% annualized) to $848bn, with one-year growth of 15.5%. It's an inopportune time in the Credit Cycle for the banking system to expand so aggressively.

There were some interesting happenings on the Bank Liability side - the new Credit instruments created in the process of financing robust asset growth. Total Deposit growth slowed markedly to a 3.3% rate during the quarter to $6.162 TN (up 7.6% y-o-y). "Fed Funds & Net Repo" Liabilities expanded at a 14.3% pace to $1.327 TN (up 11.7% y-o-y). Credit Market Liabilities expanded at a brisk 18.5% rate to $1.063 TN (up 19.4% y-o-y). Miscellaneous Bank Liabilities grew at a 36.3% pace to $1.942 TN (up 10.5% y-o-y), and Bond Liabilities increased at a 22.9% rate to $625bn (up 18.3% y-o-y). One can make a strong argument that it has not been the ideal environment to aggressively expand capital markets liabilities to fund risky loan growth.

Money Market Mutual Funds (MMF) expanded a robust SAAR $442bn to $2.490 TN. MMF assets were up 16.7% annualized during the quarter, 20.4% y-o-y and 35.9% over two years. "Security RP" holdings expanded SAAR $85.8bn during the quarter to $413bn. Credit Market Instruments increased SAAR $350.8bn, with Open Market Paper up SAAR $90.4bn (to $664bn), Treasury Securities up SAAR $38.7bn (to $89bn), Agency- and GSE MBS up SAAR $31.1bn (to 126bn), Municipal Securities SAAR $58.4bn (to $399bn), and Corporate & Foreign Bonds SAAR $132bn (to $422bn). And it has definitely been a risky backdrop for enormous money fund intermediation of late-cycle risky Credits.

"Open Market Paper" expanded a record SAAR $410bn during Q2 to $2.110 TN. This was a notable 22.4% rate of expansion during the quarter, with one-year growth of 16.7%. Virtually all Q2 growth was in Commercial Paper, although this amount and more will be reversed during the current quarter. The ABS sector issued a record SAAR $295bn of (asset-backed) Commercial Paper during the quarter (to $885bn). At SAAR $140.7bn, "Funding Corps" were the largest purchasers of Open Market Paper. Funding Corp Asset growth slowed during Q2 (to 7.1% ann.), reducing its first-half growth rate to 20.7% (to $1.681 TN). Fed Funds & Net Repo Asset growth also slowed (to an 8.2% rate), reducing the pace of first-half growth to a still blistering 19.0% (to $2.731TN)

Delving briefly into other financial operators, Life Insurance Cos. expanded Assets at a 10.2% rate during the quarter to $4.868 TN (up 8.7% y-o-y); Financial Companies at a 0.7% rate to $1.896 TN (up 2.1% y-o-y); Saving Institutions at a 1.3% rate to $1.673 TN (down 5.4% y-o-y); Credit Unions up at a 3.9% rate to $749bn (up 6.4% y-o-y); and REIT assets down at a 7.1% rate to $391bn (up 7.6% y-o-y).

As always, the Household (& Non-Profit) Balance Sheet illuminates powerful Credit Bubble dynamics. The value of Household Assets inflated $1.510 TN (nominal) during the quarter, or 8.6% annualized, to $71.672 TN. And with Household Liabilities increasing "only" $301bn, or 8.9% annualized, to $13.813 TN, Household Net Worth inflated an additional $1.206 TN, or 8.5% annualized, during the quarter to a record $57.859 TN. Expanding at an 11% annualized rate, Financial Assets increased $1.186 TN (nominal) to $44.284 TN. Real Estate Assets grew a moderate $274bn, or 4.8% annualized, to $23.193 TN.

Over the past year, Financial Asset holdings have increased $3.980 TN, or 9.9%, and Real Estate Assets $1.135 TN, or 5.1%. Total Household Assets have ballooned $5.271 TN, or 7.9%, in four quarters. With Liabilities up $1.076 TN, or 8.5%, Household Net Worth has inflated $4.195 TN over the past year, or 7.8%. Household Net Worth is up $8.512 TN, or 17.2%, in two years, certainly supporting consumer confidence and expenditures.

The Rest of World (ROW) Balance Sheet also typically exposes Credit Bubble effects. This quarter's report, unfortunately, is somewhat convoluted - and with major revisions to confuse the issue. For the quarter, the ROW acquired U.S. Financial Assets at an unprecedented SAAR $2.535 TN, while ROW U.S. Liabilities increased a record SAAR $1.934. In nominal dollars for Q2, ROW Assets holdings increased an enormous $522bn, or 14.1% annualized, to (a heavily revised) $15.366 TN. Credit Market holdings increased $215bn, or 15% annualized, to $6.947 TN. Treasury Holdings dipped $7.8bn to $2.185 TN, while Agencies jumped $86bn to $1.134 TN. Corporate Bond holdings rose $111bn to $2.990 TN.

Over the past year, ROW holdings of U.S. Assets were up an unfathomable $2.659 TN, or 20.9% (ROW Liabilities up $1.172 TN to $6.877 TN). Credit Market holdings have increased $919bn, or 15.2%. Elsewhere, Security Repos increased $265bn (28.2%) y-o-y, and Direct Investment rose $226bn (11.5%). Corporate Bonds (that include ABS) increased $787bn, while "Other" Assets were up almost $400bn and Deposits $118bn.

Second quarter numbers suggests the scope of global dollar "recycling" requirements has inflated substantially. The Federal Reserve's aggressive rate cuts earlier this week definitely only exacerbate what is becoming an untenable outward flow of dollar liquidity from the U.S. financial system to the Rest of World (that must, at a price, be "recycled" back into U.S. assets).

We believe the current course of Fed policy is an attempt to Sustain the Unsustainable. The Q2 Flow of Funds report certainly confirms the enormity of ongoing Credit creation, intensive Risk Intermediation, and Financial Sector Ballooning - Classic Credit Bubble Dynamics. The bottom line is that only extreme levels of Credit expansion and intermediation now sustain bloated and maladjusted financial, economic and asset market structures. As we've witnessed, any interruption in the Credit creation process will almost immediately instigate financial dislocation. The Fed has chosen aggressive action in hopes of resuscitating Credit excess and Bubble Perpetuation. A less risky strategy for our system and currency would necessitate air flowing the other direction - out of Credit, asset and economic Bubbles. Postponing the adjustment process at this point ensures greater future financial tumult and economic hardship.