| The markets remain unsettled, although the major U.S. stock indices ended the week with only small changes. The Dow, S&P500, and Transports were about unchanged. The Morgan Stanley Cyclical index added less than 1%, and the Morgan Stanley Consumer index was marginally positive. The Utilities gained 2%. The broader market was stronger, with the small cap Russell 2000 and S&P400 Mid-cap indices up about 1%. Technology stocks generally underperformed. The NASDAQ100, Morgan Stanley High Tech, Semiconductor, and Street.com Internet indices all declined about 1%. The NASDAQ Telecom index, however, gained about 1%. The Biotechs are strong, with this week’s 2.5% advance increasing 2004 gains to 11.5%. The financial stocks remain resilient, with the Broker/Dealers unchanged (up 9% y-t-d) and the Banks up 1% (up 4% y-t-d). Although bullion declined $1.40, the HUI gold index recovered 1% this week. By group, the S&P Homebuilding index was this week’s big gainer, rising 10%. Homebuilding traded to a record high today (up 97% over 52 weeks). The S&P Retailing index traded to a record today (up 56% over 52 weeks), as did the S&P Diversified Bank (up 36% over 52 weeks), and S&P Oil and Gas Refining indices (up 75% over 52 weeks). It was a most impressive week for the Treasury market. Despite some decent economic data, 2-year Treasury yields declined 11 basis points to 1.60%. Five-year Treasury yields dropped 13 basis points to 2.94%, and 10-year yields dropped 12 basis points to 3.98%. The long-bond saw its yield decline 11 basis points to 4.84%. So far this year, 2-year Treasury yields have declined 18 basis points, the 5-year 20 basis points, the 10-year 16 basis points, and benchmark Fannie MBS 19 basis points. The yield on Fannie Mae benchmark mortgage-backeds declined 6 basis points this week. The implied yield on December 3-month Eurodollars sank 11.5 basis points to 1.73%, the lowest since June 24. The 10-year dollar swap spread added 0.5 to 39.75. The spread on Fannie 4 3/8 2013 note widened 1 to 31, and the spread on Freddie 4 ½ 2013 note widened 2 to 30. Corporate spreads were wider, with junk bonds again notably underperforming. Bloomberg tallied about $11 billion of (non-Treasury, non-agency) debt issuance this week. Investment grade issuers included Mizuho Finance $1.5 billion, Anheuser Busch $300 million, New York Life $250 million, Ainsworth Lumber $210 million, Nortek $200 million, Hovnanian $150 million, and TTX $90 million. Junk bond funds saw outflows of $392 million this week (from AMG). And with junk spreads widening somewhat after the past year’s extraordinary collapse, power generator Calpine this week cancelled its $2.5 billion junk issue. Nonetheless, junk borrowers came to market with about $1.4 billion of paper. Issuers included Invensys $550 million, Associates Materials $445 million, Stations Casino $350 million, Readers Digest $300 million, Pinnacle Entertainment $200 million, Nebraska Book Company $175 million, and Fedders $155 million. Convert issuers included Ivax $350 million, MGI Pharma $300 million, Veritas $125 million, Bank United $100 million, and Intellisync $50 million. Foreign dollar issuers include the European Investment Bank $3 billion, Italy $2 billion, Korea Development Bank $850 million, State of Israel $500 million, and El Cajon $230 million. And while long-term corporate debt issuance has been unimpressive the past few, the asset-backed securities market is on fire. According to JPMorgan, issuers sold $16 billion of ABS this week. As has been the case of late, Home Equity Loans accounted for about half of issuance. Year-to-date issuance of $81 billion is running 29% above last year’s record pace (wow!). Broad money supply (M3) jumped $36.8 billion for the week of February 16th. M3 is up $159.3 billion over the past seven weeks. Demand and Checkable Deposits surged $24.3 billion, and Savings Deposits rose $12.6 billion. Small Denominated Deposits dipped $1.0 billion and Retail Money Fund deposits declined $4.1 billion. Institutional Money Fund deposits added $1.1 billion, while Large Denominated Deposits dropped $8.4 billion. Repurchase Agreements jumped $15.5 billion, while Eurodollar deposits declined $3.7 billion. Fed Foreign “Custody” Holdings of Debt, Agencies increased $8.3 billion to $1.142 Trillion. Custody Holdings are up $140.6 billion over 15 weeks (49% annualized). Bank Credit surged another $52.1 billion during the week of February 18, with two-week gains of almost $100 billion. For the first seven week of 2004, Total Bank Credit is up an eye-opening $207.2 billion to $6.45 Trillion. There may be an issue with respect to re-classifying off-balance sheet positions as security holdings. For the week, Securities holdings jumped $67.3 billion. Following last week’s strong gain, Loans & Leases declined $15.1 billion. Commercial & Industrial loans added $2.3 billion, and Real Estate loans increased $1.2 billion. Consumer loans gained $4.6 billion. Security loans declined $17.8 billion, while Other loans added $14.5 billion. Elsewhere, Commercial Paper (CP) dipped $6.0 billion. Non-financial CP rose $2.3 billion, while Financial CP declined $8.3 billion. Freddie Mac posted 30-year fixed mortgage rates were unchanged at 5.88%. Fifteen-year fixed rates rose 2 basis points to 4.89%. One-year adjustable-rate mortgages could be had at 3.50%, down three basis points for the week. These were the lowest adjustable mortgage rates since early July. ARM rates are down about 40 basis points a year ago, and this week accounted for 27% of total mortgages. The Mortgage Bankers Association Purchase application index rose better than 2%. Year-over-year, purchase applications were up 36%, with dollar volume up 53%. Refi applications rose 3% to the highest level since August. The average Purchase application was for $217,600 and the average adjustable-rate mortgage was for $307,500. There were 28,736 bankruptcy filings last week, down about 4% from one year ago. Commodities Watch: February 24 – Bloomberg (Jeff Wilson): “Soybean futures in Chicago soared to their highest price in more than 15 years as hot, dry weather threatened to damage crops in Brazil and Argentina at a time of surging demand for soy-based animal feed and vegetable oil. Brazil’s soybean production may fall as much as 11 percent and Argentina’s may drop 7 percent after a heat wave expected over the next two weeks…” February 26 – Bloomberg (Joe Carroll): “Natural gas traded in New York had its biggest gain in two weeks after the U.S. Energy Department reported higher-than-expected demand for stored reserves of the most widely used U.S. heating fuel. Utilities took 164 billion cubic feet of gas from storage last week, the department said. Only one of 19 analysts surveyed by Bloomberg expected a withdrawal of more than 160 billion cubic feet. If storage declines proceed at a normal pace, inventories will end the winter heating season 18 percent below the five-year average. ‘People are finding out there is a very real supply problem in North American natural gas,’ said Darcel Hulse, president of liquefied natural gas at Sempra Energy… ‘These markets are tighter than they’ve been in 20 years,’ said Steven Parla, director of energy research at Foresight Investment Solutions… ‘We’re going to continue to see structurally higher and more volatile prices.’” February 25 – Bloomberg (Claudia Carpenter): “The 5,500-pound bundles of copper plates in Mario Casiano’s three New Orleans warehouses will be gone by the end of this week, and the 38-year-old metals manager for Pacorini USA said remaining inventories at other storage depots in the city will disappear by August. Surging demand for wire, pipes and electronic parts already has emptied copper warehouses in Singapore, Barcelona and Hamburg. New Orleans is home to the largest copper pile monitored by the London Metal Exchange, which says global inventories fell 65 percent in the past year to the lowest since 1998… ‘Inventories are dropping now at really a rapid pace,’ said Thomas Baack, a 20-year veteran of the copper business who is the chief statistician at the International Copper Study Group in Lisbon. ‘The problem is if suddenly prices go up and people realize they might go up for a while, they might all scramble to cover their needs and suddenly all the available metal is gone.” February 21 – Financial Times (Kevin Morrison): “John Meyer, a metals analyst at Numis, offered advice to investors this week when he wrote: ‘We recommend investors buy anything copper: you could go down to B&Q and buy copper pipes before the price goes up; or an air conditioner - most of it is copper piping; buy the new Toyota hybrid car - it uses twice as much copper as a conventional car, so its raw material price is going up. It’s also environmentally friendly. But don’t melt your copper coins yet – they’re made of cupronickel so there’s not much copper in there.’” February 26 – Bloomberg (Christopher Donville): “The rising price of steel threatens the solvency of some U.S. construction companies, the Associated General Contractors of America said. ‘Steel-price increases have been sudden, steep and devastating,’ Ken Simonson, the…association’s chief economist said… The price of hot-rolled steel imports has soared 73 percent this year to $570 a short ton… ‘I worry that these price spikes are going to cause bankruptcies and job losses,’ said Simonson, who said the cost of steel for a single bridge project has risen by $15 million since the construction contract was signed. Construction contractors are also being squeezed by increases in the price of copper, plywood, natural gas and petroleum products such as diesel fuel and asphalt, he said.” The CRB index surged 4% this week, with a y-t-d gain of 7.6%. The best I can tell, the CRB index traded today at the highest level since July 1984. The Goldman Sachs Commodity Index rose 4.7%, with y-t-d gains of 7%. This week’s commodity performance was all the more impressive in the face of a stable-to-stronger dollar. Cooper rose to an 8-year high, with prices up 30% already for 2004. April Crude Oil ended the week at $36.16, up 5.5% for the week. Currency Watch: The dollar index was about unchanged this week. The dollar made up a little ground against the euro, and gained slightly against the yen. The real gained almost 2% this week, following a couple unsettled weeks in Brazilian financial markets. Asia Inflation Watch: February 26 – Bloomberg (James Regan): “China’s foreign-exchange reserves, the world’s second biggest after Japan’s, rose to a record $416 billion in January, the central bank said…The reserves increased from $403 billion at the end of 2003.” February 24 – Bloomberg (Jianguo Jiang): “China’s central bank forecast consumer-price inflation will accelerate to about 3 percent this year as the fastest expansion of any major economy drives up costs of coal, copper and other raw materials. Prices have been rising too fast and must be closely monitored, the People’s Bank of China said in a 2003 review posted on its Web site. China’s consumer prices increased 1.2 percent last year, with inflation accelerating to a 6 1/2-year high of 3.2 percent in December.” February 27 - Bloomberg (Melissa Stock): “Asian economies are facing increasing price pressures although the region’s central banks, with the possible exception of China, aren’t likely to start raising interest rates, the Wall Street Journal reported. Consumer prices rose in January in Singapore, Thailand, the Philippines and South Korea compared to the previous month and deflation eased in Hong Kong and Taiwan, the WSJ said. Consumer prices are forecast to continue to rise in Asia in 2004, with only authorities in China likely to take a stance against the trend, the paper said.” February 23 – UPI (Jong-Heon Lee): “High prices of crude oil and raw materials are posing a serious threat to the resources-deficient South Korean economy, with growing concerns that surging import prices will build up inflationary pressure and undermine experts and domestic consumption. Local manufacturers are striving to secure raw materials and the government has made ‘all-out’ efforts to ease scarcity of industrial resources, but analysts warn troubles would prolong, putting a heavy burden on the nation’s mainstay industrial sectors. Some experts predicted an industry-wide crisis in the coming months due to the price hike as most manufacturers are expected to run out of their current stocks of raw materials in March.” February 25 – Bloomberg (Theresa Tang): “Taiwan’s January bank lending rose at the fastest pace in more than five years as record-low interest rates and accelerating economic growth spurred companies to tap credit lines to fund expansion.” February 25 – Bloomberg (George Hsu): “Taiwan’s M2 money supply grew 6.5 percent from a year earlier in January, its fastest in three years, the central bank said…” February 25 – Bloomberg (Kate Mayberry): “M3, the most closely watched measure of money supply, rose 8.9 percent in January from a year earlier, Bank Negara Malaysia said in a statement in Kuala Lumpur.” Global Reflation Watch: February 26 – Bloomberg (Lily Nonomiya): “Japanese retail sales had their biggest gain in almost seven years in January as Isetan Co. reported record New Year sales and other clothing stores benefited from rebounding consumer confidence. Sales rose a seasonally adjusted 4.5 percent in January from December, the Ministry of Economy, Trade and Industry said in Tokyo. The gain exceeded economists’ forecasts and was the biggest since March 1997, when sales rose 7.2 percent.” February 23 – Bloomberg (Daisuke Takato): “Exports by companies including Tokyo Electron Ltd. And Murata Manufacturing Co. helped the world’s second-largest economy grow at the fastest pace in 13 years last quarter. Rising global demand for Japanese products is offsetting the effects of the yen’s 9 percent gain against the dollar in the past year, economists and company executives said… From year earlier, the trade surplus widened to 507.1 billion yen from 102.8 billion yen, the ministry said. Exports rose 11 percent from a year earlier, and imports grew 0.8 percent. Exports by volume rose 13.3 percent in January from a year earlier, the most since February 2000 and the seventh consecutive increase. Imports by volume grew 5.5 percent from a year earlier, the fifth straight monthly gain.” February 25 – Bloomberg (Laurent Malespine): “Thailand’s economy is forecast to expand as much as 8.1 percent this year, and the country may post a trade deficit of $1.5 billion, the finance ministry said. Exports may grow 13.9 percent, and imports may expand 22.3 percent for the year, the ministry said. In January, exports rose 16 percent to $7.1 billion, and imports grew 16.8 percent to $6.9 billion.” February 26 – Bloomberg (Amit Prakash): “Singapore’s economy grew faster in the October-December quarter than previously estimated… Fourth-quarter gross domestic product rose an annual 11 percent, the second straight quarter of expansion, after surging a revised 16 percent in the July-September quarter, Singapore’s Trade and Industry Ministry said.” February 26 - Financial Times (Anna Fifield) - “House prices surged by an astonishing 3.1 per cent this month, the fastest rate in almost two years, according to figures published by Nationwide… This represented a rapid acceleration from the 0.7 per cent recorded in January, and suggested that two interest rate rises in the last four months have failed to take the steam out of the overheated market. Britain’s biggest building society said the flurry of activity this month took the annual rate of inflation to 17.1 per cent, levels not reached since July last year, after slowing to 14.3 per cent, the lowest rate in almost two years, last month.” February 24 – Bloomberg (Todd White): “Spanish banks increased domestic lending by 15 percent in 2003, accelerating their pace from the previous year even as they reduced bad loans, according to data on the central bank’s Web site… New home prices rose 15.8 percent in 2003, their fastest growth pace since 1988…” U.S. Bubble Economy Watch: February 27 - Dow Jones (Deborah Lagomarsino): “The U.S. government’s budget deficit for fiscal year 2003 worsens dramatically if calculated using accrual-based accounting, according to the U.S. government's 2003 financial report… The official U.S. budget deficit, which is calculated using cash accounting, hit a record $374 billion in fiscal year 2003. That figure becomes a whopping $665 billion under the accrual method the government uses to compile its annual financial report. The main difference between the two budget figures is that the $665 billion number reflects increases in certain government liabilities, including those for veterans benefits and military retirees’ pensions and health care.” February 24 – DowJones (David Feldheim and Christine Richard): “As the securitization of conventional mortgages slows on Wall Street, large investors have been turning their attention to home equity loans, crowding out smaller buyers that end up with less available choices. These deals are backed up by riskier loans either to less creditworthy borrowers in the so-called sub-prime market or to borrowers taking out second-lien mortgages. Both types pay investors a higher yield than conventional mortgages. Surging demand for these debt instruments - from government sponsored enterprises such as Fannie Mae and Freddie Mac and Asian central banks - has meant smaller investors can be kept out of some deals… While the agencies aren't permitted to buy sub-prime and second-lien mortgages, they can purchase such mortgages for their investment portfolio if the loans are bundled into highly rated asset-backed securities.” February 27 - Bloomberg (Julie Ziegler): “U.S. households have found ways to curb the risk posed by debt levels that are growing at the fastest rate in 18 years, researchers at the International Monetary Fund said. Americans are refinancing mortgages, taking advantage of gains in U.S. equity markets since mid-2003 and diversifying financial holdings, IMF economists Chris Faulkner-MacDonagh and Martin Muhleisen said. ‘Although the increase in private indebtedness could eventually give reason for concern, other indicators suggest that households may have been careful to limit their financial ‘exposure,’ they write in the March issue of Finance and Development, an in-house magazine of the IMF… Total household debt is growing at the fastest since 1986, averaging a 10.6 percent annual rate in the first three quarters of last year, according to the Federal Reserve” February 23 – PRNewswire: “Coldwell Banker Real Estate Corporation today announced another blockbuster year for the sale of luxury homes -- valued at $1 million or more. This represents an all-time record… In 2003, Coldwell Banker affiliates sold 13,816 luxury homes priced over $1 million. This represents an increase of 24 percent from 2002. In addition, Coldwell Banker luxury home sales volume surged 23 percent to $23.3 billion, compared to the $18.9 billion mark set in 2002… ‘The luxury home market is enjoying one of its most active periods ever,’ said Alex Perriello, president and CEO, Coldwell Banker Real Estate Corporation. ‘Homeowners have built equity in their homes, and, as a result, we are seeing a significant migration of homeowners into the luxury category. We expect activity to remain strong in the luxury category with a rebounding economy, continued low interest rates and strong demographic trends that will keep demand high.’” Combined January Inbound Containers into the two major Southern California ports surged 25.3% y-o-y to 542,560. Combined Outbound Containers were up 4.3% y-o-y to 170,068. Containers returning empty jumped 9.2% to 280,415, or 52% of total Inbound Containers. Freddie Mac’s Book of Business expanded at a 10% annualized rate in January to $1.429 Trillion. MBS issued expanded at a 12.4% rate, while the Retained Portfolio decreased at an 8.9% rate during the month. Mortgage REIT Redwood Trust reported fourth quarter “core earnings” up 93% from Q42002. Total Assets increased $2.73 billion during the quarter, or 55% annualized, to $17.6 billion. Assets were up from $7.0 billion one year ago. January Existing Home Sales were reported at a somewhat weaker-than-expected 6.04 million annualized unit pace. The number of sales may have been impacted by harsh winter weather in parts of the country, and a paucity of inventory throughout California. January sales were slightly ahead of strong year ago sales, with average prices up 5.8%. January New Home sales were reported at a stronger-than-expected 1.1 million unit pace. Unit Sales were up 9.6% y-o-y, with average (mean) prices up 12.3%. Calculated annualized Transaction Value (CTV) was up a notable 23.1% y-o-y to $286.0 billion. The inventory of New Homes increased to 370,000, the highest since late 1995. Total Existing and New Home Sales were up 2.8% from January 2003, with CTV up 17.6% to $1.305 Trillion. California Housing Bubble Watch: Wednesday from the California Association of Realtors: “The median price of an existing, single-family detached home in California during January 2004 was $405,720, a 20.7 percent increase over the revised $336,210 median for January 2003… ‘Home sales continued their climb into record territory last month, hitting their highest level on record for the month of January,’ said Leslie Appleton-Young, C.A.R’s vice president and chief economist. ‘Demand for homes continued unabated… The inventory of homes for sale is nearing a critical juncture. In a more balanced market, there is a seven- to 10-month supply of homes for sale. In January, it was just two months. As a result, constraints on supply continue to impact both the availability and affordability of housing options for California families. The data continue to amaze. Year-over-year by region, prices were up 28.2% in the High Desert, 27.4% in Los Angeles, 28.5% in Riverside/San Bernardino, 24.6% in Monterey Region, 21.0% in Northern California, 25.2% in Palm Springs/Lower Desert, and 21.4% in Orange County. It is also worth noting that greater San Francisco Bay home prices were up better than $82,000, or 16.7% y-o-y, and prices were up 15.5% in the Central Valley. February 26 – Long Beach Telegraph (Don Jergler): “Median home prices in Long Beach rose 30 percent from last year. Carson, Compton, Paramount and Downey all saw 30 percent or greater year-over-year increases. ‘I have so many buyers asking ‘When is this going to stop, when is the bubble going to burst?’”said Richard Daskam, with Century 21…With no interest rate hikes in sight and the number of buyers on the market far exceeding the stock of available homes, it doesn’t look like home prices are going to come down any time soon, experts say… In response to the rising prices buyers continue to look for alternatives, such as condominiums...another market that heavily favors the seller. ‘For condo sellers under $400,000, there’s at least 15 to 20 buyers waiting,’ Daskam said, adding, ‘and the owners can name their price.’ Daskam said he believes the low inventory is helping to drive up home prices. ‘There’s next to nothing out there.’ Homes that are being listed are often ‘extremely overpriced or need a lot of work,’ he said.” February 23 - Marin Independent Journal (Keri Brenner): "'Finding a home in Marin is like trying to find a needle in the haystack,' said said (Barry Crotty, president of the Marin Association of Realtors). 'The lack of inventory has tipped the balance on the supply and demand scale to greatly favor the seller in this county and throughout the Bay Area.'" The Curious Greenspan and the GSE Chairman Greenspan’s busy schedule this week provided much to keep analysts’ minds busy. Monday he spoke before the Credit Union National Association, with an intriguing speech, Understanding household debt obligations. Tuesday he provided fascinating testimony on the government-sponsored enterprises before the Senate Committee on Banking, Housing, and Urban Affairs. Then on Wednesday, he was before the House Committee on the Budget, offering strong arguments why our government’s long-term fiscal situation is untenable. As with many of his recent speeches, there is a clear effort by Dr. Greenspan to craft his legacy in a most positive light, as well as attempt to distance the Fed from future crises. Congress must cut spending, rein in social security, deal with the unwieldy GSEs they created, and so forth; the Fed has done a truly exemplary job and Congress needs to get with the program or there will be problems. Our Fed chairman made for some good sound bites and most of what he said seems reasonable, if not genuine. But I also get the sense something more significant may be at play. Is Greenspan quietly crafting some major developments for the financial system? The first sign that something was up came with Monday’s Curious comments. “One way homeowners attempt to manage their payment risk is to use fixed-rate mortgages, which typically allow homeowners to prepay their debt when interest rates fall but do not involve an increase in payments when interest rates rise. Homeowners pay a lot of money for the right to refinance and for the insurance against increasing mortgage payments. Calculations by market analysts of the ‘option adjusted spread’ on mortgages suggest that the cost of these benefits conferred by fixed-rate mortgages can range from 0.5 percent to 1.2 percent, raising homeowners’ annual after-tax mortgage payments by several thousand dollars. Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade… American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.” What? How could chairman Greenspan endorse adjustable-rate mortgages for our aggressively borrowing household sector at this stage of the interest rate cycle? This borders on the absurd, or so I thought initially. But things began to make more sense after his Curious testimony on the GSEs. “The Federal Reserve is concerned about the growth and the scale of the GSEs’ mortgage portfolios, which concentrate interest rate and prepayment risks at these two institutions. Unlike many well-capitalized savings and loans and commercial banks, Fannie and Freddie have chosen not to manage that risk by holding greater capital. Instead, they have chosen heightened leverage, which raises interest rate risk but enables them to multiply the profitability of subsidized debt in direct proportion to their degree of leverage. Without the expectation of government support in a crisis, such leverage would not be possible without a significantly higher cost of debt.” “In general, interest rate risk is readily handled by adjusting maturities of assets and liabilities. But hedging prepayment risk is more complex. To manage this risk with little capital requires a conceptually sophisticated hedging framework. In essence, the current system depends on the risk managers at Fannie and Freddie, as good as they are, to do everything just right, rather than depending on a market-based system supported by the risk assessments and management capabilities of many participants with different views and different strategies for hedging risks. Our financial system would be more robust if we relied on a market-based system that spreads interest rate risks, rather than on the current system, which concentrates such risk with these two GSEs…” “But to fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later. As a general matter, we rely in a market economy upon market discipline to constrain the leverage of firms, including financial institutions. However, the existence, or even the perception, of government backing undermines the effectiveness of market discipline. A market system relies on the vigilance of lenders and investors in market transactions to assure themselves of their counterparties’ strength. However, many counterparties in GSE transactions, when assessing their risk, clearly rely instead on the GSEs’ perceived special relationship to the government.” Well, isn’t this interesting. After a decade of explosive GSE growth, our Fed chairman has found religion. These institutions abrogate market discipline and are a risk to future stability. And now Dr. Greenspan would like to halt their balance sheet expansion. This is big. But why today? Chairman Greenspan: “And I would say one of the reasons why the issue of Fannie and Freddie didn’t arise earlier is they weren’t large enough and they didn’t create a potential significant problem for the overall financial system that -- not that they do today, as I point out, but they will almost surely do in years ahead unless some changes are made in the structure of how these organizations function.” The GSEs ended 1998 with outstanding debt approaching $1.3 Trillion, so it is not credible to argue that they until recently “weren’t large enough and they didn’t create a potential significant problem.” The GSEs have played such prominent roles in a series of Fed-orchestrated “reliquefications” that they have operated as virtual central banking partners. For years, the Greenspan Fed has acquiesced to risky GSE expansion, and, for years, GSE and Fed interests have been in harmony. Perhaps Dr. Greenspan’s newfound resolve is related to ECB and foreign central bank demure. It would, after all, be reasonable that some might appreciate that the GSEs are the fountainhead for much of the destabilizing dollar liquidity inundating the global financial system. I can imagine the ECB’s Dr. Issing protesting that the explosion in GSE borrowings was a leading source of unsound money and Credit – fostering financial and economic imbalances. I will further conjecture that the true scope of the GSE problem became apparent to the Fed (and others) this past summer and fall. A strengthening economy set the stage for what would typically be an imminent tightening by the Federal Reserve. Between July and August, 10-year interest rate futures yields surged 120 basis points, while measures of bond market volatility exploded. The MBS market was being pummeled, the cost of hedging was skyrocketing, interest-rate markets were rapidly moving toward dislocation and the fledgling reflation/recovery was in serious jeopardy. The GSEs had relied on interest rate derivatives to hedge their ballooning balance sheets, but they had effectively become too large to hedge (the market can’t hedge itself!). And much complicating matters, the leveraged speculator community was heavily exposed, also seeking to reduce exposure to rising rates. Everyone was on the same side of the boat, and the commencing of interest rate risk off-loading (including the self-reinforcing trading by dynamic/“delta” hedging strategies - by GSE counterparties and others) was quickly exposing the untenable nature of systemic interest rate hedging. The interest rate derivatives market – one chairman Greenspan has so trumpeted as a modern marvel with myriad benefits to financial stability and economic prosperity – was faltering. Moreover, Federal Reserve interest rate policy was hamstrung by the risk of financial dislocation. But things were brought back to calm. The Fed assured the marketplace that rates would not be rising for a considerable period, while the GSEs ballooned their balance sheets with securities liquidated by the fearful speculators and hedgers. Between July and September, Fannie and Freddie Retained Portfolios expanded by an unprecedented $160 billion. This major operation worked its magic by injecting massive new liquidity, thereby lowering interest rates, fueling stock market gains, and stimulating the U.S. Bubble economy. Stock market speculation intensified and speculative excess fanned out across markets at home and abroad. And it is certainly no accident that this wild inflation also coincided with the arrival of a new leg down in the dollar bear market. This, then, set in motion greater foreign central bank dollar support, ushering in unparalleled global liquidity excess and heightened inflation throughout Asia. Never before had GSE power been as impressive or global in nature. It was also destabilizing. And while GSE and interest-rate derivative issues were anything but resolved, their resolutions were at least delayed for the Fed’s discretionary “considerable period.” It is my view that Dr. Greenspan would now like to take this opportunity and attempt a change in course -- rein in GSE balance sheet expansion and hedging operations, and get interest rate risk rebalanced away from the financial sector. But our Fed chairman has a number of dilemmas. For one, any admission that these institutions’ balance sheet operations have played critical roles in reliquefying the system during periods of heightened stress would surely lend congressional support to the GSEs. What’s a politician not to love about that? So Greenspan contrives a circumstance where the GSE business of insuring MBS functions just wonderfully and poses little systemic risk. Balance sheet operations, on the other hand, offer little positive impact (outside of boosting GSE profits), while posing considerable systemic risk. Here’s how Dr. Greenspan explains it: “There is another business (other than insuring MBS), which relates to the issue of taking part of the mortgages, which are purchased, and hold them on the balance sheets of the GSEs. These mortgages are selling at market interest rates, but if you have a subsidy in issuing debt, you are picking up an abnormal profit, which is the normal profit in the spreads plus the size of the subsidy so that the incentive to put assets on the balance sheet, whether or not they are mortgages, corporate bonds, or other things, which are on the GSE balance sheets; that, in effect, harvests the subsidy which, remember, because it is not restricted by the Congress, can be expanded at will by the GSE. And so what we have is a structure here, in which a very rapidly growing organization holding assets and financing them by subsidized debt is growing in a manner, which really does not, in and of itself, contribute to either home ownership or necessarily liquidity or other aspects of the financial markets.” “There are disputes, I must tell you, that people -- there are some people who do believe that (GSE balance sheet expansion) has some effect on securities markets. I think the evidence here is very murky and, clearly, in any event, more of a secondary issue than anything else. The crucial question are there -- these are two businesses. They are both subsidized. They both have a high rate of return on equity; indeed, the rate of return on equity on the part of the GSEs is significantly above those of, say, large commercial banks, which is an indication that they have a special advantage. And I’m saying that there is one vehicle or, I should say, one part of this business, which we should be endeavoring to get them to expand, because that’s the base on which the secondary mortgage market functions.” “The ownership of assets on the balance sheet is a very seriously lesser -- a lesser force. My own judgment is it has very little to do with either home ownership, home construction, or even -- has a -- having a very significant impact at all on interest rates. The real issue is the securitization, which is what Fannie and Freddie originated, they do an exceptionally good job technically, and my own view and why I think privatization would be the thing for them to want to do is I basically believe that if they were to fully privatize, they would be smaller organizations, their profit levels would be somewhat less, their price earnings ratios would be much higher and, in all likelihood, they may even have greater market value from a privatized organization largely because they do things so well.” Wow! This is fascinating subject matter, as it broaches the key issue of GSE growth: Does their balance sheet expansion create liquidity, thus impacting interest-rate and financial markets generally? Chairman Greenspan is arguing that they do not, and that such potentially risky operations should be limited by congress. He also conveniently avoids the critical issue of the GSEs as “Buyers of First and Last Resort for the Leveraged Speculating Community.” The capacity for basically unlimited GSE balance sheet expansion – especially in a time of heightened systemic stress - provides a momentous incentive for leveraged speculation in MBS and throughout the U.S. Credit market. To downplay the importance of GSE balance sheet expansion is Curious but not all too credible. Not surprisingly, Mr. Greenspan’s testimony elicited immediate responses from both Fannie and Freddie. From Fannie’s Franklin Raines: “By purchasing mortgages for its portfolio, Fannie Mae has been able to move independently to stabilize the mortgage market during a crisis. In so doing, it has provided an important source of stability to the market. This was clearly evident during the global financial market turmoil in the fall of 1998… Fannie Mae repeated this role of market stabilizer following the events of September 11.” Fannie and Freddie CEOs both testified before congress on Wednesday, stating (the obvious) that GSE purchases lower mortgage rates and, at crucial times, have stabilized the markets. Richard Syron, Freddie’s new CEO and former Fed bank President, wrote, “It is unfortunate that the debate has moved from a discussion of the importance of legislation to strengthen the regulatory structure of the housing GSEs to a more theoretical discussion.” Well, for too long the critical “theoretical discussion” of the GSE’s instrumental role in contemporary money, Credit, marketplace liquidity, speculative excess and economic activity has been dismissed and disregarded. Chairman Greenspan would, of course, never admit that the GSEs – in the age of unconstrained Wildcat Finance - operate as quasi central banks and nurture leveraged speculation. He’ll gladly stick with the conventional view that these institutions are incapable of creating liquidity and are far removed from markeplace speculation. And Dr. Greenspan points the finger of responsibility at congress, instructing them to attempt to resolve the issue of the markets assuming government backing of GSE debt. But surely he appreciates that the “implicit guarantee” is much more of a creature of the Greenspan Fed than it is of our Washington politicians. The Fed cannot speak of helicopter money, “unconventional methods,” and fighting deflationary forces at all cost and not have the markets absolutely convinced that the Fed would move aggressively at any indication of problems at the GSEs. Holders of GSE debt have understandable confidence that the Fed would respond to any systemic crisis by inflating the value of their holdings – they’ve done it repeatedly. Indeed, the GSEs powerful unlimited capacity to issue securities and create marketplace liquidity rests squarely with the Fed’s guarantee of marketplace liquidity and repeated market bailouts. The GSEs are the ultimate Too Big Too Fail – the ultimate Moral Hazard and no amount of legislation will alter this reality. Dr. Greenspan recognizes he has a major problem, and he is surely anxiously aware that he must attempt to rein in GSE debt growth. They have become too powerful, they now dominate (unsound) “Money & Credit,” and, importantly, GSE and Fed interests are no longer necessarily in accord. Of immediate concern, Greenspan faces an interest rate hedging nightmare. But he also fully appreciates that he cannot risk any reduction in mortgage finance Credit Availability. This leads Greenspan to become a strong advocate of GSE guarantees, ensuring the continuation of enormous Credit growth through the MBS market. But he also fully appreciates that aggressive banking system asset growth will be required to compensate for restrained GSE portfolio expansion. Yet such expansion would be especially dangerous at this stage in the interest rate cycle (not to mention the terminal phase of the Mortgage Finance Bubble). The interest rate derivative market is today untenable, and he would be adamant to minimize the banking system’s exposure to excessive interest rate risk. So a crucial aspect of his plan is to have households shoulder much more of the risk burden – Adjustable-rate Mortgages for the Masses. And with today’s active purchase and refi mortgage markets, in not all too long of a period a considerable amount of interest-rate risk can be shifted to homeowners enticed by low payments. This process is certainly supported by the myriad of alluring new ARM (and interest-only) products coming to market, which Greenspan went out of his way to trumpet Monday. The Fed can do its part by keeping interest rates artificially low. And as crazy and reckless as all of this is, it suits Dr. Greenspan just fine. Sustain the Great Credit Bubble and transfer even more risk to unsuspecting homeowners. The banks win, as they gain back market share in mortgage lending. The GSEs do fine as they insure only larger amounts of MBS. And the financial system wins generally as it earns strong profits while transferring interest rate risk to the household sector. And, as we all know by now, What’s Good for the Financial Sector, is Good For America. All I can say is the Dr. Greenspan is truly The Wizard. He is the financial genius, the artful politician, the brilliant scientist. But his experiment has “gone mad.” To proceed with his endeavor – to sustain the Great U.S. Credit Bubble - requires larger quantities of debt of increasingly risky debt. And he clearly has every intention of burdening households with unprecedented risk. He makes the ridiculous claim that household finances are in good shape, but this is only to rationalize his plan. He is in the process of thoroughly burying Americans in debt. Greenspan imparts a terrible injustice. I will stick with my view that this is despicable central banking at its absolute worst. I will again protest that Dr. Greenspan is deceitful and dishonorable. And I will protest that a reckless U.S. financial sector is more than willingly complicit in the rape and pillage of American finance. But placing all this aside, we must be especially vigilant analysts. There are potentially major financial developments afoot. And in the unfolding battle between Alan Greenspan and the government-sponsored enterprises, I would not underestimate The Enormous Power of Franklin Raines & The GSE Lobby. Maryland Senator Paul Sarbanes: “Let me just follow up on the question that the chairman just put, because I think it’s interesting. Some have argued that the GSEs provide important stability in the mortgage markets during periods of economic instability, and they site, for example, the Asian debt crisis in ‘98, or the business and bank recession of ‘90, ‘92, and argue that the mortgage rates would have increased dramatically at that time as, in fact, they did in the Jumbo mortgage market and in other credit markets, but that the GSEs’ ability to continue buying mortgages and mortgage-backed securities made a difference so that they had played an important stabilizing role. What’s your response to that?” |
Senator Sarbanes: “But did that endeavor contribute to stability?”
Chairman Greenspan: “I think it did, in part, yes.”
Senator Sarbanes: “In part?”
Chairman Greenspan: “I said I think it did, in part.”
