BEST OF DOUG NOLAND

September 20, 2005

Traditionally, Credit booms are brought to their knees by higher interest rates. For a system constrained by a limited supply of finance, heightened boom-time demand for borrowings pushes up its price (market rates). In booms of old, policy tightening would have Fed open-market operations withdraw reserves from the banking system. This would immediately restrict liquidity, both forcing lending rates higher and directly imposing (reserve) restrain on the banking system as a whole. Today, the expansive financial sector (as opposed to the "banking system") – encompassing international banks and securities firms, the GSEs, myriad insurers, finance companies, captive finance subsidiaries, public mutual funds, hedge funds, pension funds, ABS, MBS, "structured finance," central banks, and others - operates unrestrained by reserve or capital requirements. Liquidity is dictated by the unrestricted expansion of financial sector liabilities, with Fed operations reduced to little more than a symbolic gesture. And the longer and larger this Credit Bubble inflates, the greater marketplace confidence that the Fed will not risk piercing it.

Fed assurances of ample marketplace liquidity, measured policy responses, and unprecedented transparency have created the perfect environment for Borrowing Short & Lending Short. Households have little fear of variable-rate mortgages, believing that they will always enjoy equity appreciation and the option to refinance (to negative amortization if necessary!). The leveraged speculators beckon and Wall Street aggressively structures products to profit from mortgage and financial sector Credit spreads, with little concern for anything other than measured and moderately higher mortgage rates, and no fear of faltering liquidity or a Fed-induced housing/economy slowdown. And if Borrowing Short & Lending Short spreads/returns appear rather meager, well, the perceived safety of this trade guarantees that it will be put on with greater leverage – creating only more surplus system liquidity!

Again, who loses? The loser is system stability. In the now 15-months of Tightening Lite, the US Credit system will have added approximately $1.5 Trillion of risky mortgage debt. Millions of households have and continue to purchase inflated properties on highly risky mortgage terms. Over this period, the median price of a home in California has inflated another $73,000, with major gains in many markets nationally. Our accumulated Current Account Deficit over the six quarters of Tightening Lite has surpassed $900 billion. The prices of crude and natural gas have both almost doubled, while inflationary pressures are broadening. Unprecedented global liquidity has fueled debt, equity and real estate booms encompassing markets large and small, developed and developing. It’s become a runway global Credit Bubble….