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Setting the Backdrop for Stage Two

For the week, the Dow (down 3.1% y-t-d) and the S&P500 (down 5.3%) each jumped 4.3%. The Transports surged 5.9% (up 11.6%) and the Morgan Stanley Cyclicals 6.2% (down 0.3%). The Morgan Stanley Consumer index gained 1.9% (down 4.9%), and the Utilities rose 3.3% (down 4.8%). The broader market was strong. The small cap Russell 2000 jumped 4.8% (down 5.9%), and the S&P400 Mid-Caps gained 4.4% (down 2.7%). The NASDAQ100 jumped 5.6% (down 8.9%) and the Morgan Stanley High Tech index 5.5% (down 9.1%). The Semiconductors increased 5.2% (down 7.5%), The Street.com Internet Index 7.4% (down 5.4%), and the NASDAQ Telecommunications index 4.9% (down 7.5%). The Biotechs declined 0.7% (down 3.0%). The Broker/Dealers surged 7.2% (down 21%), and the Banks rallied 3.4% (down 7.9%). Although Bullion declined $6.90, the HUI Gold index increased 2.9% (up 11.4%).

One-month Treasury bill rates declined 2 bps this past week to 0.86%, while 3-month yields rose 17 bps to 1.35%. Two-year government yields jumped 39 bps to 2.13%. Five-year T-note yields rose 33 bps to 2.90%, and ten-year yields increased 24 bps to 3.71%. Long-bond yields gained 20 bps to 4.50%. The 2yr/10yr spread ended the week at 158 bps. The implied yield on 3-month December '08 Eurodollars surged 53 bps to 2.86% (high since January 14th). Benchmark Fannie MBS yields jumped 27 bps to 5.48%. The spread between benchmark MBS and 10-year Treasuries was 3 wider at 177 bps. The spread on Fannie's 5% 2017 note narrowed 11 to 55 bps and the spread on Freddie's 5% 2017 note narrowed 10 to 56 bps. The 10-year dollar swap spread increased one to 65.5. Corporate bond spreads were mostly narrower. An index of investment grade bond spreads narrowed 23 to 105 bps. An index of junk bond spreads widened to 662 bps.

Investment grade issuance included GE Capital $12.5bn, JPMorgan Chase $6.0bn, Lehman Brothers $2.5bn, XTO Energy $2.0bn, Dell $1.5bn, and Martin Marietta Material $300 million.

Junk issuers included Berry Plastics $680 million, Plains All America Pipeline $500 million, and Cobank $500 million.

Convert issuance this week included Kinetic Concepts $600 million and Steel Dynamics $500 million.

International dollar bond issuance included E.On Intl. $3.0bn, Barclays $2.0bn, Evraz Group $1.6bn and Monumental Global Funding $500 million.

German 10-year bund yields surged 22 bps to 4.13%, as the DAX equities index rallied 3.6% (down 15.2% y-t-d). Japanese 10-year "JGB" yields added 2 bps to 1.40%. The Nikkei 225 gained 1.1% (down 12% y-t-d and 21.8% y-o-y). Emerging debt markets held their own, while equities were mostly higher. Brazil's benchmark dollar bond yields added 4 bps to 6.14%. Brazil's Bovespa equities index gained 3.7% (up 1.6% y-t-d). The Mexican Bolsa added 1.6% (up 7.6% y-t-d). Mexico's 10-year $ yields rose 8 bps to 4.75%. Russia's RTS equities index gained 3.0% (down 5.0% y-t-d). India's Sensex equities index rallied 4.3%, reducing y-t-d losses to 18.8%. China's Shanghai Exchange sank 11%, with 2008 losses now at 41.2%.

Freddie Mac 30-year fixed mortgage rates were unchanged at 5.88% for the second straight week (down 29bps y-o-y). Fifteen-year fixed rates dipped 2 bps to 5.40% (down 49bps y-o-y). One-year adjustable rates dropped 8 bps to 5.10% (down 35bps y-o-y).

Bank Credit increased $2.9bn to $9.440 TN (week of 4/9). Bank Credit has expanded $227bn y-t-d, or 8.6% annualized. Bank Credit posted a 38-week surge of $797bn (12.6% annualized) and a 52-week rise of $1.031 TN, or 12.3%. For the week, Securities Credit increased $21.4bn. Loans & Leases declined $18.6bn to $6.864 TN (38-wk gain of $539bn). C&I loans slipped $2.9bn, with one-year growth of 22.2%. Real Estate loans gained $12.9bn. Consumer loans added $0.9bn, while Securities loans fell $14.8bn. Other loans dropped $14.7bn. Examining the liability side, Borrowings From Others dropped $28.4bn.

M2 (narrow) "money" supply rose $9.8bn to $7.680 TN (week of 4/7). Narrow "money" has expanded $218bn y-t-d, or 10.8% annualized, with a y-o-y rise of $469bn, or 6.5%. For the week, Currency declined $1.0bn, and Demand & Checkable Deposits dropped $23.7bn. Savings Deposits rose $27.8bn, while Small Denominated Deposits slipped $1.1bn. Retail Money Fund gained $7.9bn.

Total Money Market Fund assets (from Invest Co Inst) dropped $52.0bn last week to $3.484 TN, posting a y-t-d gain of $371bn, or 41.3% annualized. Money Fund assets have posted a 38-week rise of $901bn (48% annualized) and a one-year increase of $1.043 TN (42.3%).

Asset-Backed Securities (ABS) issuance was stable at about $4.0bn. Year-to-date total US ABS issuance of $57.4bn (tallied by JPMorgan's Christopher Flanagan) is running 25% of the comparable level from 2007. Home Equity ABS issuance of $303 million is a minute fraction of comparable 2007's $129bn. Year-to-date CDO issuance of $11.7bn compares to the year ago $131.4bn.

Total Commercial Paper fell $10.2bn to $1.807 TN. CP has declined $417bn over the past 36 weeks. Asset-backed CP dipped $2.9bn (36-wk drop of $417bn) to $778bn. Over the past year, total CP has contracted $229bn, or 11.2%, with ABCP down $304bn, or 28.1%.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 4/16) jumped $21.7bn to a record $2.240 TN. "Custody holdings" were up $184bn y-t-d, or 29% annualized, and $324bn year-over-year (16.9%). Federal Reserve Credit added $0.4bn to $867bn. Fed Credit has contracted $6.3bn y-t-d, while having increased $16.0bn y-o-y (1.9%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.418 TN y-o-y, or 27%, to a record $6.661 TN.

Global Credit Market Dislocation Watch:

April 15 - Bloomberg (Neil Unmack and Sarah Mulholland): "The credit-default swap market has become a lesson in being careful what you wish for now that Wall Street has taken $245 billion of losses partly tied to such exotica. Rather than dispersing risk and lowering borrowing costs as former Federal Reserve Chairman Alan Greenspan predicted, the contracts have exacerbated the debt crisis. What was intended as a way for lenders to protect against defaults spawned a market covering $45 trillion of bonds and loans where no one knows how much is traded and speculators who bet on deteriorating credit quality end up forcing that reality. Some credit-default indexes have morphed into what Wachovia Corp. analysts led by Glenn Schultz call 'Frankenstein's monster' because they now often drive prices in the so-called cash bond market, rather than the other way around... 'The indices are just trading on their own account with no relationship whatsoever to an underlying cash market that's ceased to exist,' Jacques Aigrain, chief executive officer of...Swiss Reinsurance Co., said..."

April 15 - Financial Times (Krishna Guha): "The credit crisis represents nothing less than a loss of confidence in the financial system, Federal Reserve governor Kevin Warsh said yesterday, warning that the healing process 'is unlikely to be swift or smooth'. 'Market participants now seem to be questioning the financial architecture itself,' he said. The fragility in short-term credit markets was 'a manifestation of that loss of confidence'... He warned 'public liquidity is an imperfect substitute for private liquidity'. The markets would return to normal only when private sector institutions were willing again to lend each other money and make markets in financial securities."

April 15 - Financial Times (Michael Mackenzie): "Strains across money markets intensified yesterday and are approaching levels last seen in mid-December when central banks announced liquidity provisions to alleviate year-end funding pressures. This was illustrated by higher swap rates, which compare the difference between overnight lending rates set by central banks and three-month Libor, the rate at which banks lend to each other... 'Despite the best efforts of the Federal Reserve to lubricate the wheels of the funding markets, the fact remains that banks still hoard cash at nearly all costs,' said William O'Donnell, strategist at UBS... 'If banks are loath to lend cash to each other, it's hard for us to see any standdown from historically tight lending standards now being reflected to consumer and institutional borrowers.'"

April 15 - Bloomberg (Tiffany Kary and Caroline Salas): "U.S. corporate bankruptcies are accelerating as the economic slowdown compounds the end of easy credit... The amount of distressed corporate bonds jumped to $206 billion April 11 from $4.4 billion in March 2007, according to a Merrill Lynch & Co. index..."

April 15 - Bloomberg (Dan Levy): "U.S. foreclosure filings jumped 57% and bank repossessions more than doubled in March from a year earlier as adjustable mortgages increased and more owners gave up their homes to lenders. More than 234,000 properties were in some stage of foreclosure, or one in every 538 U.S. households...RealtyTrac...said... Nevada, California and Florida had the highest foreclosure rates. Filings rose 5% from February. About $460 billion of adjustable-rate loans are scheduled to reset this year... Auction notices rose 32% from a year ago, a sign that more defaulting homeowners are 'simply walking away and deeding their properties back to the foreclosing lender' rather than letting the home be auctioned, RealtyTrac Chief Executive Officer James Saccacio said..."

April 15 - Financial Times (Julie MacIntosh, Francesco Guerrera and Henny Sender): "Citigroup is allowing private equity groups bidding for up to $12bn of its leveraged loans to cherry pick from a wide range of assets with different prices and credit ratings - a move that could complicate Citi's efforts to clean up its balance sheet. People close to the situation said that, rather than selling the loans as a block, Citi was asking buy-out firms including Apollo, TPG and Blackstone to choose from a menu of leveraged loans used to fund at least seven major buy-out deals... People familiar with the sale said private equity groups were likely to focus on loans linked to deals they knew well, while steering clear of those that were perceived as troubled or unlikely to recover."

April 18 - Associated Press (Alan Zibel): "Sallie Mae says it cannot write money-losing student loans indefinitely. Top executives are holding 'daily deliberations' about just how long the nation's largest student lender can afford to sacrifice its bottom line for the sake of college-bound Americans, Sallie Mae CEO Albert J. Lord said... Experts said that, unless the government intervenes or market conditions rapidly improve, Sallie Mae could have no choice but to stop writing new federally backed loans... Even though the majority of student loans are highly rated and carry a federal guarantee, investor demand for securities backed by these assets has plummeted -- a sign of just how nervous investors are about securities backed by mortgages, student loans and other debt."

April 17 - Bloomberg (Abigail Moses): "Banks worldwide are demanding 60% more in collateral from investors such as hedge funds to cut the risk of derivative trades going bad, the International Swaps and Derivatives Association said."

April 15 - Bloomberg (Edward Evans): "A record number of companies canceled initial public offerings in the first quarter...a survey by Ernst & Young LLP said. As many as 83 companies withdrew IPOs while a further 24 delayed share sales... The number of companies going public declined 60% from the fourth quarter of 2007 and was down 38% from the first three months of last year."

Currency Watch:

The dollar index rallied 0.3%, ending the week at 72.01. For the week on the upside, the Canadian dollar increased 1.5%, the South African rand 1.2%, the Brazilian real 1.1%, the British pound 1.0%, and the Australian dollar 0.8%. On the downside, the Japanese yen declined 2.5%, the Swiss franc 1.9%, the South Korean won 1.7%, and the Norwegian krone 0.5%.

Commodities Watch:

April 16 - Financial Times (Javier Blas, Isabel Gorst, and Lindsay Whipp): "The global food crisis intensified yesterday when one of the world's biggest wheat exporters halted foreign sales and rice prices shot to a record high after Indonesia stopped its farmers from selling the grain abroad. In another sign of turmoil, a big food company in Japan, Nihon Shokuhin Kako, said high corn prices had forced it to buy cheaper genetically modified corn for the first time, breaking a social, though not legal, taboo and signalling that opposition to GM foods could weaken in the face of record food prices. Meanwhile, fresh wheat export curbs in Kazakhstan, the world's fifth largest exporter, and the rice bans in Indonesia, threaten to trigger bans in other food exporting countries, which will now face much higher demand from importing countries. Hussein Allidina, at Morgan Stanley in New York, said pressure for export bans was likely to increase elsewhere as developing countries suffering high inflation tried to combat rising local prices by cutting back on exports of agriculture commodities."

April 18 - Bloomberg (Rattaphol Onsanit and Luzi Ann Javier): "Rice futures rose for a fifth day, recording the biggest weekly advance in at least seven years, on concern export curbs imposed by China and Vietnam will spread as importing nations struggle to meet their needs... 'More and more countries will have restrictions on exports,' Frederic Neumann, an economist at HSBC...said... 'There's some pressure on the Thai government to curtail shipments.'"

April 15 - Financial Times (Carola Hoyos and Javier Blas): "Russian oil production has peaked, one of the country's top energy executives has warned, fuelling concerns that the world's biggest oil producers cannot keep up with rampant Asian demand... Leonid Fedun, vice-president of Lukoil, Russia's largest independent oil company, told the Financial Times he believed last year's Russian oil production of about 10m barrels a day was the highest he would see 'in his lifetime'."

April 15 - Financial Times (Catherine Belton and Carola Hoyos): "Five years ago Russia's rapidly growing oil exports were seen as the cure for the US and Europe's addiction to Middle East oil, international oil companies' most exciting potential source of revenue and the only thing that could quench China's insatiable new thirst. But today Russia is bracing itself for its first production decline in 10 years... Leonid Fedun, vice-president of Lukoil... said Russia would be able to sustain levels of 8.5m-9m barrels a day over the next 20 years only if oil companies invested billions of dollars in tapping new fields... Mr Fedun estimated companies would need $1,000bn, far more than the $4bn extra a year Lukoil calculates will be available to the industry if Russia cuts its production taxes as is being discussed."

April 18 - Bloomberg (Lars Paulsson): "A shortage of electricity generation that shows no sign of abating is underpinning gains in global commodity prices, according to analysts at Goldman Sachs... A lack of infrastructure in South Africa, Latin America, China and Australia has led to the disruption of feedstock supplies or halted power generation... 'One of the key themes that seems to pervade the entire commodities complex is the significant shortage of power generation throughout the world,' they said."

April 17 - Bloomberg (Dale Crofts): "ArcelorMittal, the world's largest steelmaker, plans to boost prices on some steel shipments in the U.S. by $250 a ton, or about 33% of current prices, to recoup surging costs for energy and iron ore."

Gold dipped 0.7% to $918, while Silver added 0.7% to $17.82. May Copper declined 1.3%. May Crude surged $6.64 to a record $116.78. May Gasoline jumped 4.2% to a new record (up 21% y-t-d), and May Natural Gas surged 7.5% (up 42% y-t-d). May Wheat fell 3.0%. The CRB index jumped 2.9% (up 16.9% y-t-d). The Goldman Sachs Commodities Index (GSCI) surged 4.2% (up 21% y-t-d and 58% y-o-y).

China Watch:

April 16 - Bloomberg (Nipa Piboontanasawat and Li Yanping): "China ordered banks to set aside more money to slow lending after the economy grew more than economists forecast in the first quarter and inflation was close to the fastest in 11 years. Gross domestic product expanded 10.6% in the three months to March 31... 'Economic growth is still very strong and inflation is out of control,' said Jim Walker, chief economist at Asianomics... 'The authorities will need to raise interest rates a lot more and let the yuan appreciate.'"

April 14 - Bloomberg (Luo Jun, Zhao Yidi and Klaus Wille): "China's central bank chief said there's still room to raise interest rates after six increases last year, as he tries to tame the highest inflation since 1996. 'The anti-inflation policy is a combination of both quantitative measures and price measures,' Zhou Xiaochuan said... 'There's room for using interest rates further.'"

April 17 - Bloomberg (William Bi): "China, the world's largest grain producer, will increase export duties on all fertilizers and some related raw materials by 100 percentage points to ensure domestic supply for farmers during the main growing season. The changes will be effective from April 20 to Sept. 30 and will increase export taxes on fertilizer products to between 100% and 135%..."

India Watch:

April 15 - Dow Jones (Giada Cardoletti): "India's economy remains resilient to market upheavals, but inflation rose more than expected, the governor of India's Central bank said... India's inflation levels are 'unacceptable and far more intense than anticipated,' said Y.V Reddy... Inflation in India has accelerated to an over three-year high of 7.41%..."

April 15 - Financial Times (Justine Lau and Joe Leahy): "India's airline sector is expected to report losses of $1bn for the year ended last month, double that of a year earlier, according to the head of one of its biggest airlines... India's air passenger market grew at an annual compound rate of 25.5% in the four years ended in March and is expected to grow at 16% in the next two years, according to...Ernst & Young."

Latin America Watch:

April 15 - Bloomberg (Andre Soliani and Adriana Brasileiro): "Brazil's retail sales in February rose at the fastest pace since June 2004, boosting expectations that the central bank will raise interest rates tomorrow. Retail, supermarket and grocery store sales, as measured by units sold, jumped 12.2% in February from the year-ago month..."

April 15 - Dow Jones: "In the wake of last month's widespread food shortages, Argentines' expectations for future inflation rose in April to the highest level yet... Torcuato Di Tella University said...that the average projection for 12-month-out inflation came in at 32.8% in its latest survey..."

Unbalanced Global Economy Watch:'

April 14 - Financial Times (Krishna Guha, Chris Giles and Chris Bryant): "World leaders yesterday called for urgent action to tackle soaring global food prices, while promising to quickly implement measures to strengthen the international financial system and prevent a repeat of the credit crisis. The call for a global effort to deal with both the immediate food crisis in the developing world and the longer-term challenge of ensuring adequate food supplies came on the final day of the World Bank and International Monetary Fund spring meetings..."

April 13 - Financial Times (Chris Giles and Krishna Guha): "The subprime mortgage debacle was not a unique problem for the global economy but just one of many points at which an unsustainable global economic system could have shattered, Tommaso Padoa-Schioppa, Italy's finance minister, told the Financial Times. ...Mr Padoa-Schioppa insisted that the path of global economic growth had been unsustainable and the US was unlikely to be the main motor for growth over the coming decade. 'If we think that solving, or emerging from, the crisis means going back to the configuration of growth before the crisis, we would be making a mistake because we were on an unsustainable path," he said. Linking the subprime crisis to global imbalances that built up in years of low interest rates, high US consumer spending, lax lending standards and enormous trade deficits, Mr Padoa-Schioppa believes it is time to remind everyone that solving the present credit crisis will not solve the world's economic problems. 'We have been saying for years that an economy that has stopped generating savings needs a fundamental correction and it has taken the form of the subprime crisis..."

April 16 - Bloomberg (Fergal O'Brien): "European inflation accelerated more than initially estimated in March, reinforcing the European Central Bank's resistance to cutting interest rates even as economic growth cools. The inflation rate rose to 3.6% last month, the highest in almost 16 years, the European Union's statistics office in Luxembourg said today. The March figure is up from 3.3% in February and exceeds an estimate of 3.5% published on March 31."

April 18 - Bloomberg (Brian Swint): "Britain had a 10.2 billion-pound ($20.4bn) budget deficit in March, a third more than economists forecast, as capital investment increased. The shortfall was the largest for the month since records began in 1993..."

April 18 - Bloomberg (Jennifer Ryan): "U.K. mortgage lending fell 17% in March from a year earlier, the Council of Mortgage Lenders said. Gross lending against property declined to 26.3 billion pounds ($52.5bn)..."

April 16 - Bloomberg (Christian Vits and Gabi Thesing): "Inflation in Germany, Europe' largest economy, accelerated in March more than initially estimated, leaving the European Central Bank little room to cut interest rates. The inflation rate...rose to 3.3% from 2.9% in February..."

April 18 - Dow Jones (Jonathan House): "Spanish lending growth continued to slow in February... Total Spanish loans rose at an 11.8% annual rate in February, down from 12.1% growth in January."

April 18 - Bloomberg (Sharon Smyth and Ariadna Carbonell): "Spanish housing prices fell in real terms for the first time in more than a decade after higher borrowing costs deterred buyers."

April 15 - Bloomberg (Tasneem Brogger): "Iceland's economy will contract next year for the first time since 1992 and inflation will exceed the central bank's target, the government said in a revised forecast."

April 18 - Bloomberg (Jason McLure): "Ethiopia's annual inflation rate increased to 29.6% in March, the highest in over a decade, as rising food costs continued to push up consumer prices. Inflation expanded from 22.9% in February..."

April 15 - Bloomberg (Tracy Withers): "New Zealand's annual inflation rate accelerated in the first quarter... The consumer prices index rose 3.4% in the year ended March 31..."

Bursting Bubble Economy Watch:

April 15 - Market News International (Isobel Kennedy): "Treasuries traded lower Tuesday on some surprisingly strong economic news and poor inflation data... The March Producer Price Index was not a pretty picture. Overall prices were +1.1% (double the expected...)... Energy was up by 2.9% Yikes! YOY PPI is running +6.9% vs. +3.1% at this time a year ago. Bear Stearns' economists said crude wheat prices have risen 160.4% over the last year, flour prices have risen 100.0%, pasta prices are up 30.8%, and milled rice products have risen 34.8%. 'Inflation is everywhere within this report,' Bear said."

April 18 - New York Times (Andrew Martin and Kim Severson): "Shoppers have long been willing to pay a premium for organic food. But how much is too much? Rising prices for organic groceries are prompting some consumers to question their devotion to food produced without pesticides, chemical fertilizers or antibiotics. In some parts of the country, a loaf of organic bread can cost $4.50, a pound of pasta has hit $3, and organic milk is closing in on $7 a gallon... Food prices in general have been rising, but organic food lagged somewhat behind last year because of a temporary glut of organic milk and other factors... In recent months, however, these factors have been giving way to cost pressures in the industry. On grocery shelves across the nation, sharp price increases are taking hold. 'It's probably the most dynamic and volatile time I've seen in 25 years,' said Gary Hirshberg, chief executive of Stonyfield Farm, an organic dairy business. 'It's extremely difficult to predict where it's going.'"

April 17 - The Wall Street Journal (Jeffrey McCracken): "More companies than ever are in the weakest of liquidity positions and struggling to cover their bills, according to a Moody's...report... There are now 47 companies with public debt that Moody's rates as having the weakest of liquidity levels, a number that has more than doubled since June. These 47 companies have combined rated debt of $34.7 billion."

April 15 - Financial Times (Daniel Pimlott): "Tens of thousands of US students may face problems paying their college bills this year as the student loan market becomes the latest victim of the credit crisis. A rising number of private and public lenders have been backing out of offering student loans, hit by the fallout from the credit squeeze and the declining profitability of federally insured education loans. The problem is becoming increasingly urgent because most loans are arranged between now and August... Loans to students presently in college in the US totalled $78bn in 2006-07... But since last August at least 50 private and non-profit lenders, who in 2006 lent to 800,000 students and provided 13% of loans, have withdrawn their services, according to Finaid.org... A 'very significant' proportion of the rest of the market is set to follow, according to Tom Deutsch, of the American Securitization Forum..."

Central Banker Watch:

April 14 - Financial Times (Aline van Duyn): "Henry Kaufman, the distinguished Wall Street economist, has added his voice to the debate about the Federal Reserve's role in the credit crisis... 'Certainly the Federal Reserve should shoulder a substantial part of this responsibility. . . it allowed the expansion of credit in huge magnitudes," Mr Kaufman said. 'Besides its monetary policy approach, [the Fed] really indicated very clearly that it was performing its role as a supervisor . . . in a minute fashion, not in an encompassing fashion. Monetary policy had a high priority, supervision and regulation within the Fed had a smaller priority."

April 17 - Bloomberg (Christian Vits and Gabi Thesing): "European Central Bank council member Axel Weber said the bank will assess whether current interest rates are high enough to contain 'intolerably' high inflation. 'Recent wage dynamics in conjuncture with elevated and persistent energy and food price pressures have increased the risk of a prolonged period of intolerably high inflation... We will have to continuously monitor closely all incoming data and evaluate whether the current level of interest rates in fact ensures' price stability."

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

April 16 - Bloomberg (Shannon D. Harrington and Abigail Moses): "Credit-default swaps worldwide expanded to cover $62.2 trillion of debt in 2007 as investors rushed to protect against losses triggered by the collapse of the U.S. subprime mortgage market. Contracts outstanding rose 37% in the second half of 2007 from...the first half, the... International Swaps and Derivatives Association said... The market, which has grown from $34.5 trillion in 2006, doubled in each of the previous three years as traders used the derivatives as a cheaper and easier way to invest in corporate debt. 'While the amounts at risk are just a fraction of notional amounts, these give us a good sense of market activity,' ISDA Chief Executive Officer Robert Pickel said..."

April 16 - Bloomberg (Abigail Moses): "The $62 trillion market for credit derivatives needs regulating to prevent a 'calamitous chain' of market failures, Credit Suisse Group's head of investment banking, Paul Calello, said at the industry's biggest gathering. 'All sectors of the financial system need to act -- both regulators and industry,' Calello told the International Swaps and Derivatives Association conference... 'There will be new regulation, and there should be; voluntary efforts are not enough.'"

April 15 - Financial Times (Aline van Duyn and Michael Mackenzie): "'Tranche warfare' has broken out in the $450bn market at the heart of the credit crunch as hard-hit investors scrap over the pools of debts that make up -so-called collateralised debt obligations. Some investors in the differently rated and ranked slices of CDOs - known as tranches - have taken advantage of the - little-noticed terms in the -structuring of such instruments to seize control of the assets and cut off payments to other debt-holders. Such conflicts have resulted in lawsuits as investors question the rights of others, such as senior noteholders who supposedly hold the least risky tranche of a CDO... The fights between tranche owners is another example of how little attention investors paid to the exact terms and conditions in the rush to complete CDO deals. It also highlights the potential for stress in the structured finance market, as ratings downgrades of assets backing bonds in turn trigger more losses or ratings downgrades."

April 15 - Bloomberg (Mark Pittman): "Standard & Poor's said it's likely to cut the AAA credit ratings on $52.7 billion of securities backed by subprime home loans because of expectations for an increase in mortgage defaults and losses."

Mortgage Finance Bubble Watch:

April 14 - Dow Jones (Marshall Eckblad): "Wachovia Corp.'s controversial Pick-a-Payment mortgage program lets borrowers choose between four monthly payment amounts. Unfortunately for Wachovia, these 'Pick-a-Pay' borrowers are increasingly inventing a fifth choice: Not making mortgage payments at all... On Monday, Wachovia conceded total losses from Pick-A-Pay loans could eventually amount to a staggering 7% to 8% of the loans' combined value, a range of $8.5 billion to $9.7 billion - meaning the bank, and its shareholders, will likely be coping with Pick-a-Pay losses for years to come."

Real Estate Bubble Watch:

April 16 - Bloomberg (Peter S. Green): "Home prices in New York's Long Island suburbs fell in the first quarter from a year ago and the number of properties for sale rose as the prospect of a recession and limited credit reduced demand. The median price in Nassau County fell 2.3% to $449,500 and inventory rose 6.5% to 9,862 homes, appraiser Miller Samuel Inc. said... In Suffolk, the median fell 6.5%... 'The market is certainly weaker than it's been in the last couple of years,' said Jonathan Miller, president of... Miller Samuel. 'You've got prices that are generally flat, sales activity showing weakness and inventory rising.'"

GSE Watch:

April 15 - Financial Times (Saskia Scholtes): "Fannie Mae and Freddie Mac...came under regulatory pressure to improve counterparty risk management of mortgage servicers, insurers and derivative trading partners they rely on to collect and guarantee mortgage payments or to hedge interest rate exposure. The Office of Federal Housing Enterprise Oversight's annual report to Congress on Tuesday said that both the government-sponsored mortgage financiers 'remain a significant supervisory concern' because of still-needed progress on internal controls, corporate governance and risk management... 'Counterparties, which represent a significant exposure to Fannie Mae, may be unable or unwilling to honour obligations should their financial strength continue to decline,' the report said."

April 9 - Forbes (Maurna Desmond): "With quietly expanded authority to support loans for borrowers far up the economic scale from their traditional low- and moderate-income mandate, the U.S. government-backed agencies are, at least for now, counteracting the downward pressure on American home prices. New rules for FHA loan eligibility were evident on Wednesday, when the Mortgage Bankers Association reported a 12.9% jump in applications for loans backed by U.S. government programs such as the FHA and the Veterans Administration... This barometer rose to 375.2, nearly three times the previous year's level. Bill Glavin, special assistant to FHA Commissioner Brian Montgomery, said he 'isn't surprised' by the spike. In February, a congressional stimulus package passed and gave the FHA 30 days to come up with new loan limits. In March, the FHA increased its loan maximum to $729,750 from $362,790 for single family-homes... Glavin said 'newly eligible people are just starting to catch on and apply for these loans.' ...Glavin said, 'It's a group that is buying more expensive houses, though there are a lot of people that don't consider themselves affluent who live in $700,000 homes.' As a part of the congressional mandate, the FHA was told to look at the 3,200 metro areas in the United States and offer mortgages up to 125% of the median home price... In 75 areas, the loan limit doubled."

April 17 - Forbes (Joshua Zumbrun and Maurna Desmond): "Touted as a savior in the housing crisis by Congress and the White House, the Federal Housing Administration is being turned into a bank's best friend. Major U.S. lenders are again aggressively enticing risky borrowers, offering FHA-backed mortgages with attractive terms and as little as 3% down. Meanwhile, the agency watches as its liabilities balloon. As a result, the nation's mortgage market is quietly undergoing a radical and potentially risky transformation that shifts liability for hundreds of billions of dollars on to the government's books... Bill Glavin, special assistant to FHA Commissioner Brian Montgomery, says the FHA has been 'inundated' with requests by business-strapped banks to become FHA-certified lenders. He expects the FHA to increase loan volume by 168.2% in fiscal year 2008 (ended September 30), insuring 1.14 million loans, up from 425,000 in 2007. The agency expects to guarantee $224 billion worth of loans in 2008. On Thursday, Ginnie Mae--a government-owned company with more than two-thirds of its securities portfolio comprised of FHA-backed loans--announced a 114% surge in volume. They issued $39.1 billion in the first quarter of 2008, up from $18.3 billion during the same period last year. The company also expects its total portfolio of outstanding securities to grow to more than $600 billion by the end of the year, reflecting a 35.2% increase..."

Fiscal Watch:

April 15 - Financial Times (Aline van Duyn): "The US government's need to provide financial backing to the state-sponsored mortgage financiers that dominate the US housing market could pose a risk to the country's triple-A credit rating, Standard & Poor's, the credit rating agency, said... In the event of a deep and prolonged US recession, S&P said the potential costs of propping up government-sponsored enterprises like Fannie Mae and Freddie Mac, which have implicit government backing, could cost the US government up to 10% of GDP. The costs of supporting broker-dealers like Bear Stearns in a dire economic situation would be much lower, at below 3% of GDP, S&P said. 'The size of GSEs, coupled with their current level of common equity, could create a material fiscal burden to the government that would lead to downward pressure on its rating,' the S&P report said... Policymakers are pushing for Fannie Mae, and Freddie Mac and the lesser-known Federal Home Loan Banks to pump liquidity into the US mortgage market... In the second half of 2007, about 90% of new mortgage funding was provided by GSEs. They have about $6,300bn of public debt and mortgage securities outstanding, more than the $5,100bn of outstanding US government debt. Fannie Mae and Freddie Mac have no formal state guarantees but investors believe the US government would step in if the system got into trouble. This allows the agencies to raise funds at very low rates...in spite of high levels of leverage."

April 15 - Bloomberg (Sarah Mulholland): "Student loan companies should be able to borrow from the U.S. using the loans as collateral, Tom Deutsch, deputy executive director of the American Securitization Forum, testified in Congress today. Student loan companies have stopped or cut back on making new loans under the Federal Financial Education Loan Program in recent months as it becomes harder for lenders to raise money and more expensive to write new loans. 'If no relief is found, the total supply of loans available through all the various programs will likely not be able to efficiently and effectively meet student demand this fall,' Deutsch said..."

California Watch:

April 16 - Los Angeles Times (Peter Y. Hong): "Southern California's historic housing slump worsened in March as bargain-hunters buying foreclosed properties pushed median sales prices down to levels last seen in early 2004... DataQuick's analysis shows California median home prices dropping by roughly $2,300 per week over the last year...'March was the seventh consecutive month in which sales have fallen to the lowest level on record for that particular month.' Across Southern California, sales were down 41.4% from year-ago levels. Median sales prices dropped 5.6% from February levels, to $380,000 -- the lowest level since April 2004, and a decline of 23.8% from peak pricing levels of $505,000."

April 15 - Los Angeles Times (Peter Y. Hong): "The median sales price of Southern California homes fell below $400,000 in March... The total number of homes sold, 12,808 in Southern California, was about half the average March sales total since DataQuick began compiling its statistics in 1988... Foreclosed homes accounted for more than a third of homes sold last month. Nearly 38% of homes sold in March had been foreclosed at some point in the prior year, up from 8% in March 2007."

April 17 - Bloomberg (Dan Levy): "Home sales in the San Francisco Bay Area dropped 41% to the lowest level for a March in two decades....DataQuick... said... The number of houses and condominiums sold in San Francisco, Santa Clara, Marin and six other counties fell to 4,898, the seventh consecutive month that sales reached a record low... The median price decreased 16.1% from a year earlier to $536,000."

Speculator Watch:

April 17 - Dow Jones (Kathy Shwiff): "Hedge funds worldwide had $2.65 trillion in assets under management at the beginning of 2008, up 27% from a year earlier, according to... HedgeFund Intelligence... Globally, 391 hedge funds had assets of at least $1 billion, representing about 80% of the total assets in the industry. Of those funds, 255 are based in the U.S., with 144 in New York... New York-based funds had $973 billion in assets at year-end, up 50% from a year earlier."

Setting the Backdrop for Stage Two:

Martin Feldstein, Harvard professor and former chairman of the President's Council of Economic Advisors, wrote an op-ed piece in Wednesday's Wall Street Journal - "Enough with Interest Rate Cuts" - worthy of commentary.

"It's time for the Federal Reserve to stop reducing the federal funds rate, because the likely benefit is small compared to the potential damage. Lower interest rates could raise the already high prices of energy and food, which are already triggering riots in developing countries. In order to offset the inflationary impact of higher imported commodity prices, central banks in those countries may raise interest rates. Such contractionary policies would reduce real incomes and exacerbate political instability.

The impact of low interest rates on commodity-price inflation is different from the traditional inflationary effect of easy money. The usual concern is that lowering interest rates stimulates economic activity to a point at which labor and product markets cause wages and prices to rise. That is unlikely to happen in the U.S. in the coming year. The general weakness of the economy will keep most wages and prices from rising more rapidly. But high unemployment and low capacity utilization would not prevent lower interest rates from driving up commodity prices.

Many factors have contributed to the recent rise in the prices of oil and food, especially the increased demand from China, India and other rapidly growing countries. Lower interest rates also add to the upward pressure on these commodity prices - by making it less costly for commodity investors and commodity speculators to hold larger inventories of oil and food grains. Lower interest rates induce investors to add commodities to their portfolios. When rates are low, portfolio investors will bid up the prices of oil and other commodities to levels at which the expected future returns are in line with the lower rates. An interest rate-induced rise in the price of oil also contributes indirectly to higher prices of food grains. It does so by making it profitable for farmers to devote more farm land to growing corn for ethanol."

While I concur with the basic premise of the article (stop the cuts!), the substance of Mr. Feldstein's analysis leaves much to be desired. First of all, I find it strange than he would address the issues of overly accommodative Federal Reserve policy, commodity prices, and inflationary pressures without so much as a cursory mention of our weak currency. The word "dollar" is nowhere to be found - not a mention of our Current Account Deficits. The focus is only on interest rates - and such one-dimensional analysis just doesn't pass muster in our complex world.

Most remain comfortably oblivious to today's inflation dynamics. Mr. Feldstein mentions increased demand from China and India. He seems to imply, however, that portfolio buying (financed by low interest rates) by "commodity investors and speculators" is providing the major impetus to rising inflationary pressures generally. Perhaps it could have something to do with the $2.5 TN increase in global official reserve positions over the past two years (85% growth). I would also counter that destabilizing speculative activity is an inevitable consequence - rather than a cause - of an alarmingly inflationary global backdrop.

I'll remind readers that we live in a unique world of unregulated Credit. Excess has evolved to the point of being endemic to an apparatus that operates without any mechanism for adjustment or self-correction. There is, of course, no gold reserve system to restrain domestic monetary expansions. Some years back the dollar-based Bretton Woods global monetary regime lost its relevance. And, importantly, the market-based disciplining mechanism ("king dollar") that emerged at times to ruthlessly punish financial profligacy around the globe throughout the nineties has morphed into a dysfunctional dynamic that these days nurtures self-reinforcing excesses. The "recycling" of our "Bubble dollars" (in the process inflating local Credit systems, asset markets, commodities and economies across the globe) directly back into our securities markets rests at the epicenter of Global Monetary Dysfunction.

A historic inflation in dollar financial claims was the undoing of anything resembling a global monetary system, and now this anchorless "system" of wildcat finance is the bane of financial and economic stability. To be sure, massive and unrelenting U.S. Current Account Deficits and resulting dollar impairment have unleashed domestic Credit systems around the globe to expand uncontrollably. Today, virtually any major Credit system can and does inflate domestic Credit to create the purchasing power to procure inflating global food, energy, and commodities prices.

The long-overdue U.S. Credit contraction and economic adjustment could change this dynamic. But for now there are reasons to expect this uninhibited Global Credit Bubble to instead run to precarious extremes - and for resulting Monetary Disorder to become increasingly problematic. Destabilizing price movements and myriad inflationary effects are poised to worsen. The specter of yet another year of near-$800bn Current Account Deficits coupled with huge speculative flows out of the dollars is just too much for an acutely overheated and unstable global "system" to cope with.

I hear pundits still referring to a "deflationary Credit collapse." Well, the U.S. Credit system implosion was largely stopped in its tracks last month. The Fed bailed out Bear Stearns; opened wide its discount window to Wall Street; and implemented unprecedented liquidity facilities for the benefit of the marketplace overall. Central banks around the globe executed unparalleled concerted market liquidity operations. Here at home, the GSEs' regulator spoke publicly about Fannie and Freddie having the capacity to add $200 billion of mortgages to their balances sheets, with the possibility of increasing their guarantee business as much as $2 TN this year (certainly including "jumbo" mortgages). The Federal Home Loan Bank system was given the ok to continue aggressive liquidity injections and balloon its balance sheet in the process. And now (see "GSE Watch" above) we see that the Federal Housing Administration (with its new mandate and $729,550 loan limit) is likely to increase federal government mortgage insurance by as much as $200bn this year, while Washington's Ginnie Mae is in the midst of a securitization boom.

Together, the Fed and Washington have effectively nationalized a large portion of both mortgage and market liquidity risk. It is, as well, worth noting that JPMorgan Chase expanded assets by $80.7bn during the first quarter (20.7% annualized) to $1.642 TN, with six-month growth of $163.3bn (22.1% annualized). Goldman Sachs expanded its balance sheets by $69.2bn during Q1 (24.7% annualized) to $1.189 TN, with half-year growth of $143.2bn (27.4%). Even Wells Fargo grew assets at an almost 14% pace this past quarter. And we know that Bank Credit has expanded at a 12.6% rate over the past 38 weeks. Meanwhile, GSE MBS issuance has been ramped up to a record pace. And let's not forget the Credit intermediation function now being carried out by the money fund complex - with assets having increased an unprecedented $371bn y-t-d (41.3% annualized) and $900bn over the past 38 weeks (47.7% annualized). It is also worth noting the $184bn y-t-d increase (29% annualized) in foreign "custody" holdings held at the Fed. Sure, the Credit system remains under significant stress, with additional mortgage and corporate Credit deterioration in the offing. But, at least for now, policymakers have successfully stemmed systemic deleveraging. The Credit system is simply not in deflationary collapse mode.

I could not be more pessimistic with regard to our economy's prognosis. And certainly much more severe Credit problems lay ahead. I could argue further that recent Credit system developments are indeed consistent with the unfolding "worst-case scenario". Yet I tend this evening to see benefits from analyzing the current backdrop in terms of the conclusion of the first Stage of the Crisis. The key aspect of this "first Stage" was a breakdown in Wall Street's highly leveraged risk intermediation and securities speculation markets. The speed and force of the unwind was extraordinary and in notable contrast to traditional banking crises that track real economy developments. "Resolution" came only through the Federal Reserve and federal government assuming unprecedented risk - and at a cost of an unprecedented policymaking mix of interest-rate cuts, marketplace interventions, and government guarantees. It is worth pondering some of the near-term ramifications.

First of all - and as the market recognized this week - yields had been driven to excessively low levels. Fed funds are today ridiculously priced in comparison both to the inflationary backdrop and to global rates. Mr. Feldstein is calling for a halt to rate cuts when it would be more appropriate for the Fed to move immediately to return rates to a more reasonable level. They, of course, would not contemplate as much. So I will presume that today's non-imploding Credit system - replete with government-backed mortgage securitizations, government-guaranteed bank Credit, presumed government-backstopped money funds and a recovering debt issuance apparatus - will suffice in the near-term in generating Credit sufficient to perpetuate our enormous Current Account Deficits. This is no minor point.

I have in past Bulletins made the case that U.S. Credit and Economic Bubbles had become untenable - the scope of Credit and risk intermediation necessary to support the maladjusted economy had become too large. Extraordinary measures to effectively "nationalize" mortgage and market liquidity risk change somewhat the direction of the analysis. I would today argue that the risk of a precipitous economic downturn has been reduced in the near-term. As a consequence, U.S. Credit growth could surprise on the upside with risk to global Price Instability increasing markedly.

I would argue firmly that - in the face of a rapidly weakening economic backdrop - global inflation dynamics coupled with our highly maladjusted economy ensure intractable trade deficits. I would further argue that the current inflationary backdrop will prove an impetus to Credit creation - that then begets only more heightened inflationary pressures. There are certainly indications that the over-liquefied global "system" is not well situated today to handle more dollar liquidity (akin to throwing gas on a fire). Inflation and its consequences have quickly become major issues around the world.

With crude hitting a record $117 today, there is every reason to expect that newly created global liquidity will further inflate energy, food, and commodity prices generally. The Goldman Sachs Commodities index has gained 21% already this year. But when it comes to Monetary Instability, our financial markets might just prove the unappreciated wildcard. When the Fed and Washington radically altered the rules of U.S. finance last month, they placed in jeopardy huge positions that had been put in place to hedge against and profit from systemic crisis. With the end of "Stage one" arises a major short squeeze in the Credit, equities, and derivatives markets. And when it comes to contemplating the scope and ramifications of today's "hedging" activities, we're clearly in Uncharted Waters. It is not beyond reason that a disorderly unwind of "bearish" Credit market positions could incite a mini bout of liquidity, speculation, and Credit excess that exacerbates Global Monetary Instability - while Setting the Backdrop for Stage Two of the Crisis.


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