-->Bubble Blower

The Daily Reckoning

London, England

Thursday, July 01, 2004

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*** New era for rates...uh huh. Soft landing? Hahahahaha...

*** Angels cry...investors yawn...lumps believe anything...

*** Poor Becks...the fault is in our stars after
all...housing bubble on the banks of the Monongahela...and
more!

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Yesterday, the world ended, not with a bang but with a
whimpering little rate increase of 0.25%.

The news fell upon the world like an aging Congressman down
the capital steps. No one cared or thought it would make
any difference. But the Fed's move marked the end of a
trend that has lasted for 25 years.

"A new era for rates," says today's International Herald
Tribune's front-page story. The Fed's goal, the paper tells
us, is a 'soft landing.'

For the last quarter of a century, the entire world economy
has been flying - higher and higher - on the Fed's jet fuel
of easy credit. But there are limits to everything. The
higher you go, the thinner the atmosphere. Eventually, you
get so high you begin to hallucinate and gasp for air.

We listen to the wheezing every day. There are things we
know now, and things we will not know until tomorrow or the
next day. What we know now is that this 'new era' is an era
of 'flation - but we don't know yet whether this heavy
breathing is inhaling or exhaling. Are prices going up...or
down? So far this week, like the last one, the evidence was
mixed. Gold plunged on Tuesday. Oil and commodities seemed
to be heading down too, with Brent crude hitting $33, also
on Tuesday. Bonds went up on Wednesday. And China's outlet
store, Wal-Mart, cut its sales forecast in half. Meanwhile,
Freddie Mac, one of America's leading mortgage debt
enablers, reported a 53% drop in profits for 2003.

On the other hand, India said its GDP grew more than 8% in
the first quarter - it's fastest growth in 15 years. And
the government expects the economy to grow at 7% to 8% a
year for the next decade."A strong pickup in industrial
activity also appeared to increase demand for the services
sector, which grew 13.8 percent in the last quarter of
2003-2004," said AP.

And Japan? The widely reported rise in consumer spending in
Japan is hardly a 'done deal.' Sales for May came in 2.5%
lower than the same period a year ago. The Avis of world
economies may be a good investment...but its recovery from
a 14-year-long slump may or may not come without
complications.

China, meanwhile, is trying for its own 'soft landing.' It
too was launched into space by the Great Enabler, Alan
"Bubbles" Greenspan. The Fed chairman gave Americans money
to spend that they had not earned. The Chinese rushed to
help them get rid of it. Thus did the old era establish a
convenient symmetry: excessive consumer spending by
Americans led to excessive capital spending by the Chinese.
Both economies are now far above the earth, hoping to get
back on the ground without injury.

The metaphor is nice enough. Cut back on the fuel - by
raising the key Fed rate 0.25% - and the great airplane
will gradually fly lower...and then come to a soft, safe
landing.

Which only goes to show the trouble with metaphors. The
world economy has come to depend on credit from the Fed at
give-away rates. Households, companies and speculators have
built their lives, businesses, and portfolios around them -
and left themselves with less margin for error than any
generation in history. A man who now spends all his income
and has a 6% mortgage cannot painlessly adjust to a 7%
rate. Something has to go. When it does, a whole swarm of
bright, buzzing business strategies, carry trades, and
hopes for the future begin to crash and burn. Pretty soon,
the ground is littered with them.

Neither the U.S. economy nor the Chinese one is a
mechanical device, after all. And neither engineers nor
economists can hope to understand it...or control it.

That job falls to us: moral philosophers, humorists,
kibitzers and agents provocateurs. Only we appreciate the
heights of madness to which the world has risen. Only we
will get a chuckle when the conceits of the Greenspan era
smash to ground. And only we have our own non-resident
genius, the Great Mogambo, who always has the 'mot juste'
for any occasion.

Soft landing?

What would Mogambo say?

"Hahahahaha..."

More news from our New World team:

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Eric Fry, our man on Wall Street...

- Mr. Greenspan raised rates. Mr. Market yawned...the Dow
Jones Industrial Average added 22 points to 10,435.48,
while the Nasdaq gained 13 points to 2,048.

- The Federal Open Market Committee hiked short-term
interest rates by a quarter-point yesterday, just as
expected...and the pinstriped pooh-bahs also promised to
continue raising rates at a"measured" pace, just as
expected. Thus, the Fed funds rate now stands at 1.25%,
just as expected. But yesterday's quarter-point hike barely
begins to fulfill the lumpeninvestoriat's lengthy list of
expectations for Mr. Greenspan's monetary machinations.

- The lumps expect Greenspan to adjust the Fed funds rate
as needed to maintain the value of the dollar and to foster
economic growth and to dampen inflationary pressures and to
facilitate employment growth and to perpetuate the bull
market in stocks and to nurture the steady appreciation of
home prices and, if possible, to reduce geopolitical
tensions, urban crime and teen pregnancy.

- Although the Fed funds rate stands only 125 basis points
tall, most investors see it as a financial Colossus of
Rhodes. But maybe this itty-bitty interest rate can't
really do what so many believe it can do. And maybe the guy
who pushes this rate around doesn't really possess the
wisdom and omnipotence that we ascribe to him. Maybe - and
now we are merely speculating - Greenspan is a mortal,
capable of error. Indeed, he could be erring as we write.

- The FOMC's well crafted press releases do not change the
fact that Greenspan is holding short-term rates well below
the inflation rate - a condition that bond fund manager
Bill Gross terms,"atrociously speculative." Even after
yesterday's rate hike, the U.S. inflation rate is nearly
triple the Fed funds rate. In other words, Greenspan is
still gunning the U.S. economy with easy money. Under the
guise of a"moderate" and"measured" monetary policy, he is
joyriding in an $11 trillion economy.

- A 1.25% Fed funds rate in a land of 3% to 4% inflation
encourages the kind of speculation that leads to
dislocations known as bubbles. A"neutral" rate of, say,
3.5% would tend to discourage most of the most reckless
forms of speculation. Why then does this speculative rate
persist?

-"The 1% federal funds rate is an emergency rate without
an evident emergency," wrote James Grant in advance of
yesterday's rate hike,"and it has to go up - at a
'measured' pace if possible, faster if necessary. Such is
the new word from the Federal Reserve Board."

- To the delight of Wall Street pundits, yesterday's FOMC
press release contained the"new word." Said the FOMC:
"With underlying inflation still expected to be relatively
low, the committee believes that policy accommodation can
be removed at a pace that is likely to be measured."

- The financial media have latched on to the Fed's new
favorite word like a newborn to its mother's breast.
Yesterday's Wall Street Journal featured the following
poorly edited line:"As the Federal Reserve embarks today
on its project to moderately raise interest rates a
measured amount that is moderate and measured, the consumer
picture is distinctly odd."

- Should the inclusion, or exclusion, of a specific
adjective in an FOMC press release, carry such weight in
the financial markets? Should it dictate the destination of
trillions of investment dollars? We, here at the Daily
Reckoning, value semantic nuance as much as anyone. After
all, word selection and sentence structure are the tools of
our trade. But should these linguistic apparatuses also be
the tools of American finance?

- By according such an outsized significance to the word
"measured," investors are engaging in a kind of mock-heroic
farce - not unlike a music historian crediting Beethoven's
quill with creating his 5th Symphony.

- Mr. Market does whatever he wishes, no matter which words
the Fed chooses to describe its activities. Is measured
such an important word after all? What if the Fed's release
instead contained the word,"gradual" or"incremental" or
"step-by-step?" Would the world be such a different place?

- Or let's imagine that the Fed admitted its limitations by
replacing the word"measured" with a word like"whimsical"
or"capricious" or"haphazard." Sure, the Dow would fall
100 points or so initially, but the financial world, where
real money is made and lost, would not have changed one
iota...and within 48 hours, every journalist in America
would begin emphasizing the wisdom of the Fed's promise to
raise interest rates in a"capricious" manner.

- Enough already! Enough of the tortured linguistic
analysis. Here's an idea: Let's try to buy good stocks and
to sell bad ones.

"But man, proud man,
Drest in a little brief authority...
Plays such fantastic tricks before high heaven
As make the angels weep."


- Shakespeare's"Measure for Measure"

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Bill Bonner, back in London:

*** 1980-2004...Bush-Reagan...could two periods be any less
similar? U.S. consumer debt hit a new record, came the news
yesterday, at $9.185 trillion, or 110% of take-home pay. As
a percentage of earnings, it is nearly twice was it was in
the early '80s. In 1980, Americans prepared for a long bust
- and a boom followed. Twenty-four years later they prepare
for a long boom, while a bust is surely on its way.

*** Poor David Beckham. The metro-masculine half of the
'Posh and Becks' celebrity team seems to be in disgrace in
London. At least, that was the implication of the TIMES
cover from yesterday. A photo shows a poster of the soccer
star after the English team lost a critical match. An
illiterate fan had written 'Looser' over Beckham's face.

*** We have been thinking more about the 'transit of
Venus.' You'll recall, dear reader, that the fault lies not
in ourselves, but in our stars. Venus does what she does.
Somehow, someway - science spends its time trying to
clarify how these things work - we do what we do. We
pretend to think our way forward. We pretend we know what
we are doing and have a good reason for everything. But why
do we think what we think? Venus. Mars. The heavens...God,
the devil...and the deep blue sea. Thoughts arise, we know
not wherefrom.

"I'm sometimes amazed by what comes out of my own mouth,"
said a friend at dinner last night."Where did that idea
come from, I wonder. I didn't know I thought that."

We offer no explication here this morning. We merely pause
to listen to the angels weep and appreciate the triste
elegance of it all.

What set off this minor reflection? An article in the Daily
Mail, in which Amanda Platell regrets the 'selfish
singletons' among her 40-something friends. They believed
they could do a better job of designing their lives than
nature or tradition. Instead of marrying and having
children, as generations had done before them, these people
created a new era of their own. Rather than suffering the
stresses and strains of family life, they built careers and
friendships...furnished their apartments from Ikea...and
voted for Tony Blair.

Now, Tony Blair's favorite think tank is worried about
them. It calls them the Lonely Generation."Two million
people face a future alone..." a report concludes.

"By the end of the next decade," Platell explains,"the
children of the Sixties will be in their '70s and many of
them will be paying a price...

"They were the ones who placed sexual satisfaction above
enduring love and self-fulfillment above self-sacrifice.

"Of course there are those among them who say that so long
as you have friendships, families don't matter. They claim
the old and lonely will socialize with - and care for -
each other.

"It's a neat idea, but one that owes more to hope than
reality. Ask yourself this question: how many of your
friendships have lasted longer than a decade? And how many
of your current friends could you reasonably expect to look
after you if you had Alzheimer's, or cancer...?

"No I'm afraid that kind of unconditional love only usually
comes from family..."

At least your family would put you in a nursing home where
you could drool without the neighbors noticing.

*** Pittsburgh correspondent, Byron King, on the housing
bubble on the banks of the Monongahela:

I was riding the street railway into downtown Pittsburgh
this morning. I noticed a billboard in the trolley car,
advertising units in an apartment complex. I happen to know
that this apartment complex is real estate of significant
quality. This particular rental property has architectural
merit, and was recently rebuilt from the inside out, up to
a very good specification. It is, in short, a very nice
place to live.

It is even nicer now, because the ad said:"$99 Deposit -
Two Months FREE Rent."

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The Daily Reckoning PRESENTS: Following yesterday's much-
anticipated FOMC meeting, Chris Mayer inspects America's
money machine and concludes that the driver may not wield
as much power as you might think.


BUBBLE BLOWER
by Chris Mayer

Despite all its position of power, prestige and privilege,
the economy lies still beyond the grasp of the central
bank. The bank can influence, but it cannot control. It can
turn on the hose, but it can't aim it. While this was true
in its earliest days, it is even more so today.

Central banking was created during times when the banks
were at the heart of borrowing and lending, and hence at
the heart of money and credit creation, and yet today -
that situation is no longer true.

As Martin Mayer [no relation to your editor] has observed
in his book"The Fed", the Fed's control over the money
supply has diminished because non-bank financial
institutions realize so much credit creation and"credit
could be substituted for money at the margin in many
guises." The new reality of our credit-soaked economy is
that control of the money supply is virtually impossible.
The capital and money markets now dominate finance, with
banks only a subset.

The distinction between money and credit is sometimes a
blurred one in today's world. We won't get into the finer
distinctions here. For us, it is enough to know that
credit, like money, represents ready purchasing power.
Purchasing power that is increasingly being manufactured
outside of the sphere of banking and used to finance the
purchase of assets such as stocks and real estate. Non-bank
financial institutions, notably the GSEs Fannie Mae and
Freddie Mac, but also others non-bank finance companies,
have driven the creation of a seemingly bottomless and
borderless money market.

This is a point that Doug Noland at PrudentBear has been
hammering away at for years, which is mainly to get people
to appreciate the contemporary financial system's
extraordinary ability to create credit unrestrained by the
traditional reserve requirements that bind banks. Fannie
Mae, for example, can create instruments (its notes) that
can be held as money market fund holdings. It has the
ability to facilitate the creation of additional purchasing
power through money market fund intermediation. Banks do
not have to be involved at all. An initial deposit made at
a money market fund can create additional deposits at a
greater rate than traditional bank deposits, again, because
the money markets are not part of the reserve requirements
of banks.

In fact, as Grant notes in the Interest Rate Observer, less
than 3.6% of today's broadly defined money stock is subject
to reserve requirements, as opposed to 38% in 1959. This is
important because the Fed's primary means of influencing
the money supply is to create (or restrict) additional bank
reserves through its open market purchases (or sales) of
government securities held by banks. It is through these
open market operations that the Fed tries to maintain its
Fed funds rate target. It does not even control that with
certainty; we are not talking about a rate that is set. The
Fed strongly influences that rate so that it may appear to
be set, but it does not set it in a formal sense.

Through open market purchases, the Fed can create
additional reserves that can then be used for lending
activities that, the Fed hopes, will stimulate the economy.
This is the standard playbook of any central bank. Increase
bank reserves and it's like adding a little booze to the
party; tighten up the reserves (open market sales) and they
are, to use the old phrase, taking away the punch bowl.

Bank reserves facilitate lending, constrained by reserve
requirements, which creates a multiplier effect on the
reserves. If banks can lend out 90% of their deposits, then
a $10 million initial purchase by the Fed leads to $9
million in lendable funds, which (assuming the loaned funds
stay in the banking system) then create $8.1 million in
lendable funds for another bank and on and on it goes. The
money markets can create additional money market fund
deposits (readily available funds that can be used to
settle transactions) without the inhibition of bank reserve
requirements.

Even though the Fed can create bank reserves, it cannot
force lenders to lend or borrowers to borrow, though there
are very strong incentives for both to do. But the modern
money markets no longer need the banks or their reserves to
finance incredible amounts of financial assets (stocks,
mortgages, etc.). There is a seemingly insatiable demand
for money market funds that are continually plowed back
into the credit creation process and lead to higher asset
prices. It is just such a process that has fueled the
housing bubble.

No credible future historian of our era will neglect the
GSEs, Fannie and Freddie, whose tremendous contribution to
the credit creation process will stand out like the
Petronas Towers in Kuala Lampur's skyline.

It appears to be open season on the twin GSE giants of
finance, Fannie and Freddie. Everyone, it seems, is taking
shots at remaking or modifying various aspects of these
monstrous credit creations. In a May 6 speech, William
Poole, President of the Federal Reserve Bank of St. Louis
laid out a devastating criticism of risks in Fannie and
Freddie's operations (let's call them FF for short, as
Poole does). While many of us have undoubtedly heard these
arguments before, it is noteworthy when it comes from the
mouth of a Federal bureaucrat - there is definitely a shift
in the wind against the mortgage behemoths.

Poole's comments focus on FF's propensity to borrow at
short-term rates and lend at long-term rates. FF magically
performs these feats of courage with a thin capital base.
This combination has led to the production of healthy
profits and returns on equity in the vicinity of 30
percent, not to mention the adulation of many investors.

According to Poole, about 34% of FF's total assets are
financed with short-term debt. The obvious risk is that
these debts re-price faster than FF's assets. If you
finance a 30-year mortgage at 6.0% with a short-term (say,
one-year) loan at 2.0%, you make a healthy spread on your
money. But, at the end of one-year, that 2.0% loan re-
prices at market rates. If interest rates rise, say to
3.0%, then your profit margin is cut by about 25% and you
still have 28-years of risk left. A situation can easily be
envisioned where FF is way under water on these assets.

FF claims to have hedges in place protecting it against
interest-rate risk. First, I would note that hedging simply
transfers that risk to another party. This is an important
point because that interest-rate risk, though it may be
hedged by FF, is still borne somewhere in the financial
system - perhaps by banks, hedge funds or other
institutions. Secondly, the quality of FF's hedge book has
been called into question. The usefulness of FF's stress
testing has been doubted.

Poole noted that FF's hedge is far from perfect. A
reversion to spreads available only as recently as 2001
could cost Fannie about 20% of their reported net income
for 2003. While such a turn would likely crush the stock
price, it would not likely cause immediate problems for
Fannie's solvency. However, if the market should come to
distrust the creditworthiness of Fannie's paper it could
create larger problems. FF rolls over some $30 billion in
short-term obligations every week. In the event of a
crisis, the market may be unwilling to soak up so much
paper at least not without a significant adjustment in
pricing. As Poole says,"The fact is that FF depend
critically on continuous market access, and with their
minimal capital positions that access could be denied
without warning." FF maintain capital positions of only
about 3.5% on their assets - not including off-balance
sheet items, which would likely balloon that leverage even
further.

I have the distinct feeling that when the GSEs are finally
stricken by crisis, it will be written as if it were
obvious all along. Just as the history of LTCM - where one
is prone to shake one's head and say"my goodness what were
they thinking?" - so too, future readers will just shake
their head, as it will all seem so obvious by then.

When the post mortem of this great credit bubble era is
written historians will focus on money and credit. They are
not going to consult the CPI or PPI. They are not going to
look at productivity figures, or job reports or
manufacturing utilization rates. They are not going to pay
much attention to the comings and goings of political hacks
- no, they are going to write about the massive growth of
money and credit as the seed of the monetary meltdown of
western civilization. They are going to write about what
happened to our money.


Regards,

Christopher Mayer,
for The Daily Reckoning