Credit Crunch: Where Do We Stand? Occasional Paper 76
30Thomas A. RussoO c ca s ion a l P a p e r 76Credit Crunch:Where Do We Stand?Group of Thirty, Washington, DC
About the AuthorThomas A. RussoVice Chairman and Chief Legal Officer of Lehman BrothersThe views expressed in this paper are those of the author and do notnecessarily represent the views of the Group of Thirty.This material has been prepared by Thomas A. Russo and is not a productof the Lehman Brothers Research Department. It is for informationalpurposes only. Lehman Brothers makes no representation that theinformation contained in this document is accurate or complete. Opinionsexpressed herein are those of Thomas A. Russo and not Lehman Brothers.All levels, prices and spreads are historical and do not represent currentmarket levels, prices or spreads, some or all of which may have changedsince the issuance of this document.ISBN I-56708-140-1Copies of this report are available for 20 from:Group of Thirty1726 M Street, N.W., Suite 200Washington, DC 20036Tel.: (202) 331-2472, Fax: (202) 785-9423E-mail: info@group30.org WWW: http://www.group30.org
Occasional PaperNo. 76Credit Crunch:Where Do We Stand?Thomas A. RussoPublished byGroup of Thirty Washington, DC2008
ContentsPageAcronyms and Abbreviations5Introduction7Consumer spending as a share of GDP9Real personal consumption and disposable income9Household net worth9Unemployment rate and average hourly earnings10Consumer confidence10Energy “tax” on consumer spending10Household debt burden — financial obligations ratio11The consumption challenge11Mortgages outstanding11Non-agency mortgage resets12Subprime mortgages 60-day delinquencies12Foreclosure forecasts12National home price inflation13Wealth effect on consumer spending growth13Net mortgage equity extraction13Mortgage lending standards14ABX.HE implied spreads over libor14Credit card debt outstanding15Credit card 30 -day delinquencies15Credit card and other consumer lending standards15Credit card fixed-rate spreads over swap rates16Subprime auto ABS 60-day delinquencies16Prime auto fixed-rate spreads over swap rates16Securitizations17Credit card securitizations18Auto securitizations18S&P 500 implied volatility (VIX)18Treasury yields19Gold and oil prices19
How does global liquidity play into this?19U.S. M&A transaction value20The Fed’s global reach20U.S. trade position with Europe, Canada, OPEC, China20International reserve assets excluding gold (world)21Comparative returns21#1 Gold bubble (gold spot prices)22#2 Tech bubble (Nasdaq composite index – CCMP)22#3 Housing bubble (S&P super compositehomebuilding index – S15Home)22#4 Global liquidity bubble? (iShares MSCIEmerging Market index – EEM)22Bank balance sheets23Reduction in asset ntribution to GDP growth from net exports27GDP share of exports to U.S.27Share of growth due to exports to U.S.27Uses of cash-out refinancing28Size of sovereign wealth fund market28Recent SWF investments in banks / investment banks29Group of Thirty Members31Group Of Thirty Publications Since 199035
Acronyms and AbbreviationsABCPABSABXAlt-AAlt-BARMbp or SWFstrVIXy-o-yAsset-backed commercial paperAsset-backed securityA series of credit default swap indices referencing deals in the home equity loan sector,issued half-yearly and broken down into sub-indices by rating buckets (AAA, AA, A, BBBand BBB-). Each ABX index references 20 home equity loan deals, and each sub index iscomposed of 20 equally weighted ABS credit default swaps referencing cash bonds, onefrom each deal (see also ABX.HE)Mortgage loans for those with a good credit score, but who lack normal documentationMortgage loans that straddle the credit score spectrum between subprime and Alt-A mortgages. Typical borrowers have very little equity in their homesAdjustable Rate MortgageBasis pointsBillionNasdaq composite indexCollateralized debt obligationCentral Intelligence AgencyDisposable personal incomeEuropean Central BankiShares MSCI Emerging Markets Index FundFederal Housing AdministrationForeign exchangeGross domestic productU.S. Department of Housing and Urban DevelopmentHigh yieldInternational Monetary FundLondon Interbank Offered RateLeft-hand scaleLoan-to-valueMergers and acquisitionsMortgage-backed securitiesNorth American Free Trade AgreementOrganisation for Economic Co-operation and DevelopmentOffice of Federal Housing Enterprise OversightOrganization of the Petroleum Exporting CountriesPersonal consumption expendituresPercentage pointQuarterQuarter-over-quarterRight-hand scaleStandard & Poor’sSeasonally adjusted annualized rateStructured investment vehiclesSovereign wealth fundsTrillionVolatility indexYear-over-year
IntroductionThis paper was presented by Thomas A. Russo on November 30, 2007, during the Group of Thirty’s 58thplenary on a panel entitled: “Credit Crunch: Where Do We Stand?” The paper was updated as of January17, 2008, in preparation for the World Economic Forum Annual Meeting 2008 in Davos, Switzerland.In the paper, Mr. Russo weaves together a narrative of the interrelated forces that are unfolding in thecurrent economic environment. To begin, he focuses on the U.S. consumer, who has been crucial to economic growth and yet now finds himself increasingly levered and under duress. Mr. Russo explains howthe declining housing market, exacerbated by stress in the mortgage market, has left consumers unable toborrow from their homes to finance consumption. He then details the increasing signs of contagion frommortgage-backed securitizations to other markets such as credit cards and auto loans, as general uneasinessgrows and as challenged consumers begin to struggle to pay other debts. As nervousness spreads acrossmarkets, Mr. Russo describes a flight to quality and to hard assets, leading to rising prices for gold, fine art,oil, etc. The paper goes on to tackle the role of liquidity, questioning whether we are in the midst of a globalliquidity bubble contributing to excess valuations of certain assets. Finally, Mr. Russo comes full circle to theU.S. financial “crisis” where bank balance sheets are backing up with assets, potentially further reducingcredit creation, further pinching the consumer.Against this backdrop, the paper concludes with policy proposals aimed at ameliorating the current situation. Mr. Russo calls for broad-brush approaches to addressing subprime mortgages; an extension of theU.S. Department of Housing and Urban Development and Federal Housing Administration programs tokeep borrowers in their homes; targeted tax incentives; discount window action; an expansion of volumecaps of state housing authorities; and a lowering of the federal funds rates. Thomas A. Russo is Vice Chairman and Chief Legal Officer of Lehman Brothers.
Consumer spending as a share of GDP%Consumer spending is the main driver of U.S. GDP7371 Consumer spending has been a rising share of GDP,currently accounting for about 70%. The health of the consumer is therefore a majordriver of the overall economy. U.S. consumer spending is important to globalgrowth. Exports to the U.S. account for 25% ofCanada’s GDP, 22% of Mexico’s, and 8% of China’s(see appendix, page 02Source: Commerce Department; data through 3Q07.Real personal consumption and disposable incomeConsumption is supported by income % y-o-y108 The marginal propensity to spend out of a dollar ofincome is nearly 1, leaving the savings rate close tozero. Consumer spending virtually never falls outside ofrecessions. Even in periods of weak income growth,consumers will continue to spend by drawing downtheir savings. Even in recessions, spending on essentials such asmedical and housing services virtually never turnsnegative. Healthy income gains over the past few years haveunderpinned consumer spending.PCE6420DPI-2-4Mar-52 Mar-61 Mar-70 Mar-79 Mar-88 Mar-97 Mar-06Note: PCE personal consumption expenditures; DPI disposablepersonal income.Source: Commerce Department; data through 3Q07. Shaded barsdenote recessions.Household net worth .and wealth% y-o-y20.0Housing boom Consumers respond with long and variable lags tochanges in wealth. About 60% of household assets are financial, androughly 30% are residential real estate. However, changes in financial wealth affect onlya portion of the population since the majority isheld by the top tier of the income distribution. Incontrast, homeownership is spread more evenlyacross income levels. Household net worth will likely start to decline ona year-over-year basis in the first half of 2008.15.010.05.00.0-5.0-10.0Tech bust-15.0Mar-60 Mar-68 Mar-76 Mar-84 Mar-92 Mar-00Source: Federal Reserve Flow of Funds; data through 3Q07.
Unemployment rate and average hourly earningsAverage hourlyearnings, rhs%6.5%y-o-y4.56.04.05.53.55.03.04.52.54.0Unemp rate, lhs3.5Signs of a softer job market are starting to emerge There is an inverse relationship between unemployment and earnings. Higher unemployment reduces employee bargainingpower and as such leads to slower wage growth. The unemployment rate increased from 4.4% inMarch 2007 to 5.0% in December 2007. Higher unemployment leads not only to lowerper capita wages, but it also hurts consumerconfidence.2.01.5Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07Source: Bureau of Labor Statistics.Consumer confidenceIndex (1985 100)115110 contributing to a decline in consumer confidence Consumer expectations of future financial andeconomic conditions trend with personal consumption. If consumers expect the economy to weaken, theymay cut back spending and increase precautionarysaving. Consumer confidence has been falling amidconcerns about housing weakness, turbulence infinancial markets and rising energy prices.105100959085807570Jan-05 Jun-05 Nov-05 Apr-06 Sep-06 Feb-07 Jul-07 Dec-07Source: Conference Board; data through December 2007.Energy “tax” on consumer spending% y-o-y4.0Higher energy prices add to the strain About 6% of consumption is directed towardenergy. In periods of rising energy prices, a greater portionof consumer budgets must be used for energyconsumption, causing consumers to cut back ondiscretionary spending. This is an energy “tax,” which equals change inenergy prices weighted by the share of personalconsumption. The latest increase in energy prices amounts to abouta 1% “tax” on income.3.02.01.00.0-1.0-2.0Mar-60 Sep-67 Mar-75 Sep-82 Mar-90 Sep-97 Mar-05Source: Commerce Department; Lehman Brothers Economics; datathrough 4Q07 (December estimate).10
Household debt burden — financial obligations ratio% of disposable incomeMeanwhile, the consumer is very levered19 Total household debt has grown rapidly over thepast five years, largely due to a jump in mortgagedebt. The burden of servicing debt is at an all-timehigh. The financial obligations ratio, which estimatesrequired payments on outstanding debt (includingmortgages, consumer loans and auto loans), hasbeen rising as a share of disposable 0Mar-05Source: Federal Reserve Flow of Funds; data through 3Q07.The consumption challengeMortgage market problems and the contagion into credit markets and banks pose an additional challengeto structionMortgage creditproblemsNon-mortgagecreditConsumption?Bank lendingMortgages outstandingSubprime( 1.2tr)14%Alt-A/Alt-B( 1.2tr)13%The housing boom, in its later stages, wassupported by aggressive mortgage lending in anenvironment of lower underwriting standardsAgency( 4.0tr)44%Jumbo( 2.7tr)29% Subprime mortgage origination surged in 2005 and2006 in response to lower underwriting standardsand higher home prices. In 2006, subprime loans accounted for just over20% of total origination, up from 8.6% in 2001. Similarly, origination of Alt-A/Alt-B (near-prime)mortgages climbed.Source: Lehman Brothers Mortgage Strategy; LoanPerformance; datathrough 3Q07.11
Non-agency mortgage resetsSubprime ARMs originated in 2005–06 will reset tohigher rates over the next several quarters bn180160140 About two-thirds of subprime mortgages outstandinghave adjustable rates. About 550bn or 2.8 million subprime loans willreset before 2009. On average, monthly payments will likely jump20% to 25%, boosting average monthly paymentsby 300 a month. Given tight lending standards, weak demand, andfalling home prices, it will be difficult to refinanceor make a sale. As such, many borrowers will beforced to default on their mortgages.1201008060402001Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09SubprimePrimeSource: Lehman Brothers Mortgage Strategy.Subprime mortgages 60-day delinquencies30The jump in subprime resets should add to alreadyhigh delinquency rates 25 Early performance of 2006 and 1H07 loans hasshown more than twice as many delinquencies asnormal (e.g., 2002). Based on early performance, cumulative defaults ofsubprime loans originated in 2006 and 1H07 couldbe about 40%. The 2005 subprime vintage has performed betterrelative to 2006 and 2007. However, there havebeen recent signs of deterioration in the 2005vintage.% 20064860Deal Age (months)Source: Lehman Brothers Mortgage Strategy; LoanPerformance.Foreclosure forecastsUnits, 000s%1,200Forecasts1,0002.52.08001.5 and ultimately to foreclosures given the weakhousing market and reduced availability ofmortgage credit Based on early performance and subprime resets,Lehman Brothers mortgage strategists estimatethere will be a total of 2 million homes foreclosedover the next two years. This is about 3 times the normal foreclosure rate. Foreclosures will add to already-bloated inventoryand sell at discounted prices, putting downwardpressure on home prices.6001.04000.520000.01992 1994 1996 1998 2000 2002 2004 2006 2008Foreclosure, lhsForeclosure rate, rhsNote: The graph only measures foreclosures of single-family existinghome sales. With condos/coops, foreclosures would likely beabout 20% higher.Source: Lehman Brothers Mortgage Strategy.12
National home price inflation% y-o-yForecastsStress in the mortgage market has exacerbatedthe huge imbalance between housing demand andsupply, further depressing home prices20Case-Shiller national index15OFHEO index10 National home prices will most likely fall by themost since the Great Depression. Expect the Case-Shiller index to fall 15% from peakto trough and OFHEO to fall 10%, with risks to thedownside. Case-Shiller is likely a better representation of actualhome prices since it tracks homes with all types ofmortgages, unlike OFHEO which is limited to Mar-04Mar-08Source: OFHEO; S&P Case-Shiller; Lehman Brothers Economics;forecasts as of 4Q07.Wealth effect on consumer spending growth% q-o-q, arFalling home prices and tighter credit shouldrestrain consumer spendingForecast2.0housing The literature on the “wealth effect” suggestsconsumers boost spending anywhere from 2 to 8cents on every dollar of perceived permanent gainsin housing wealth. Given easy credit and financial innovation, theupper end of this range probably applies. Using a 6 cents wealth effect and assuming homeprices fall 10% over the next 2 years, the housingwealth effect on consumption has swung from anestimated 1.4pp to -0.4pp by end of 2009.1.00.0-1.0stock mkt-2.0Mar-90 Jun-93 Sep-96 Dec-99 Mar-03 Jun-06 Sep-09Note: Analysis uses OFHEO home prices.Source: Lehman Brothers Economics; forecasts as of 3Q07.Net mortgage equity extraction bn, SAAR%1,20012One of the major channels to realize changes inhousing wealth is mortgage equity extraction1,00010 Mortgage equity extraction is one way to realizechanges in housing wealth (in addition to changingsavings patterns or other borrowing). Net equity extraction has tumbled from a peak of anannualized 989bn, or 10% of disposable income,in 1Q06 to 436bn in 3Q07. There are likely lags between changes in equityextraction and consumption. See appendix (page 28) for uses of cash-outrefinancing.8008600640042002001998 1999 2000 2001 2002 2003 2004 2005 2006 2007net equity extraction, lhs% disposable income, rhsNote: SAAR seasonally adjusted annualized rate.Source: James Kennedy, Federal Reserve Board; Lehman BrothersEconomics; forecasts for 4Q 2007.13
Mortgage lending standardsIn response to rising delinquencies and weakhousing fundamentals, mortgage lenders haveaggressively tightened lending standardsNet % reporting tighter standards6856Allprimenontraditionalsubprime443220 Lending standards have tightened for all types ofmortgages. Lending standards for subprime loans started totighten markedly in the beginning of 2007, virtuallyeliminating the space. Subprime originators have left the market or havelaid off people. In contrast, we have just started to witness tighterlending standards for prime mortgages, which islargely driven by jumbo urce: Federal Reserve Senior Loan Officer Survey; data throughOctober 2007.ABX.HE implied spreads over liborFinancial markets have responded in a similarfashion—demand for mortgage-backed securitieshas plunged, pushing up spreads and draggingdown pricesbp3,500AAAAAABBBBBB-3,0002,5002,000 We have witnessed a jump in even highly ratedsubprime securities in response to both poorremittance performance and risk aversion. The market is pricing about a 25% loss in poolsof mortgages underlying subprime MBS, whichtranslates into an assumption of a 50% defaultrate. By way of example, the ABX market for single-Abonds is assuming 100% principal loss on thesebonds and receipt of interest only. 6 months ago, before the turmoil, the market waspricing about 8% to 9% losses, and 1 year ago itwas pricing 4% to 5% 7Source: Markit Partners; data through January 16, 2008.14
Credit card debt outstanding% y-o-y25During housing boom,growth in credit carddebt slowed2015The challenge to liquidate money from home equityhas left consumers to finance spending throughother sources (e.g., credit cards and anticipation ofincreased wages) During the housing boom consumers could cleanup their credit card problems by taking money outof their homes. Over the past year, credit card debt has been growingat a faster pace than it has in the previous 4 years. However, year-over-year growth in credit card debtis still below the 10% average growth rate of thepast rce: Federal Reserve Board; data through November 2007.Credit card 30 -day delinquencies%There are signs of stress in the credit card sector6.56.0 Credit card delinquencies have started to pick upfor the major issuers. It is likely that credit card delinquencies will increasefurther with a lag as consumer budgets becomestretched and mortgage delinquencies continue kJan-05Capital OneJan-06Jan-07BofAChaseSource: Company 10D filings; data through November/December2007.Credit card and other consumer lending standardsNet % reporting tighter standards40Lenders are tightening standards for non-creditcard debt, and further tightening in the comingquarters is expected30 Banks have started to tighten lending standards forconsumer loans (such as auto and other big-ticketitems) with the exception of credit cards. Loose lending standards for credit cards suggestsconsumers can boost credit card borrowing tofinance consumption. However, anecdotal evidence suggests banks arestarting to grow increasingly concerned, which willlikely encourage banks to ultimately tighten lendingstandards.605020100-10-201Q96 3Q97 1Q99 3Q00 1Q02 3Q03 1Q05 3Q06credit cardnon-credit card consumer loansSource: Federal Reserve Senior Loan Officer Survey; data throughOctober 2007.15
Credit card fixed-rate spreads over swap ratesbpThe market is already anticipating credit problems450 400350300250A jump in spreads likely reflects both averse marketsentiment and concern about credit card an-06AJan-08BBBSource: LehmanLive; data through January 10, 2008.Subprime auto ABS 60-day delinquencies%Early signs of credit problems in the auto loanmarket are starting to emerge.4.54.03.5 Delinquencies have started to pick up in the recentvintages for subprime, particularly 2007. Similar signs of deterioration are appearing in theprime sector.3.02.52.01.51.00.50.0012243648Deal Age (months)20032004200520062007Source: Lehman Brothers and Intex; based on representative dealsfrom one selected subprime issuer (AmeriCredit).Prime auto fixed-rate spreads over swap rates which are also seemingly priced into financialmarketsbp450400 an-07Jan-08BBBSource: LehmanLive; data through January 10, 2008.16The rise in spreads reflects both increasing concernsabout future performance and overall marketsentiment.
SecuritizationsParts of the securitization markets are frozen, and parts are still functioning at higher spreadsValue ( bn)2004200520062007 73293410 99582813 8554256 6945185Credit CardsCredit CardsTotal 61 72 66 93MBSMBS TotalPrimeNonprime 743395349 1,069591478 1,063584479 620404216Asset ClassAutosAutos TotalPrimeNonprimeFloorplan Mortgage issuance has fallen sharply, while autosecuritizations are down less than mortgages, andcredit cards were actually up through 2007. August was a very low issuance month becauseof the spread increase in securitized products andbroader market volatility. Credit cards and auto securitizations rebounded inthe fall, but spreads remain high. At a minimum, 2008 credit card and auto securitizations will only get done at higher spreads.Much of the decline in mortgage issuance has been over the past 6 months. Autos have shown signs of adecline in volume, and for now credit cards have remained somewhat stableCredit -07Jul-07Aug-07Sep-07Oct-07Nov-07Dec-07AutosPrime MBSSubprime MBSValue ( bn)# of dealsValue ( bn)# of dealsValue ( bn)# of dealsValue ( bn)# of deals 53511979883111652849171410151414481931 1333826911356942934845711348831 0176 urce: Intex (as of January 10, 2008; final ’07 volumes may adjust higher); Lehman Brothers' Public and Private Issues ABS Database.17
Credit card securitizationsAuto securitizationsCredit card securitizations are less likely to havethe same performance deterioration as mortgagesAuto securitizations also have some characteristicsthat may insulate the market relative to mortgages Credit card securitizations use a revolving mastertrust that purchases new receivables monthly. Credit card issuers can more easily alter thequality of the credit card receivables sitting inthe trust.The payment size (approximately 300/month onaverage) is smaller, and since the loans are fixedrate, there is no reset/payment shock. However, those credit card issuers would haveto warehouse higher credit risk receivables ontheir balance sheets.But auto loans are sensitive to unemploymentlevels; if unemployment keeps rising, auto loanperformance could deteriorate significantly. Already, delinquencies are rising as consumers getstretched, which can restrain auto sales, ultimatelylowering securitization volumes. For domestic captive/quasi-captive issuers (Ford,GMAC, and Chrysler), this is important sincesecuritization is core to their funding strategies. Spreads have widened (BBBs by about 400 bps), andissuers are retaining lower-rated assets as demandhas dried up for risky assets. Coming full circle, as ABS markets tighten, creditto consumers to purchase autos is restricted,further reducing auto sales, which further hurts theeconomy. Plus, spreads have widened, indicating nervousness. Recent unemployment data, together withgrowing recession concerns, will translate intohigher charge-offs and losses on credit cardportfolios. We have already started to see credit card issuersreact by increasing their loss reserves.S&P 500 implied volatility (VIX)35The “fixed income infection” is impacting theequity markets30 The S&P is about 13% off of its highs.25 There are other factors such as expectations offuture corporate profits; however, it all becomessomewhat circular in nature since credit impactsfuture profitability. Nevertheless, volatility is rising, scaring many“committers of ep-07Jan-08Source: Bloomberg; data through January 16, 2008.18
Treasury yields%This is creating a flight to quality and away fromcredit extension 9.08.07.0 Treasuries are rallying, while swap spreads arewidening, reflecting a willingness to hold only thehighest quality counterparty risk (i.e., not financialinstitution risk). Long-term U.S. government bonds are relativelyscarce as well; perhaps this is why U.S. termrates appear to have lost their link with domesticeconomic fundamentals.10 yr6.05.04.03.02.02 : Bloomberg; data through January 16, 2008.Gold and oil prices /oz 0095908580757065605550gold, lhsoil, rhs and the ultimate flight to quality and/or to hardassets (e.g., commodities) Gold and oil prices have risen dramatically since themarket troubles began. Even fine art, an asset with a finite supply, hasappreciated dramatically in the face of the globalliquidity glut. The rally in commodities reflects a safe-haven investment, but it also reflects excess global liquidity.Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08oz ounce; brl barrel.Source: Bloomberg; data through January 16, 2008.How does global liquidity play into this?Credit creation LQ Bc Lc, where LQ equals liquidity, Bc equals borrowers’ confidence, and Lc equalslenders’ confidence So how does credit creation slow? Liquidity is driving technicals and perhaps even fundamentals, not the other way around. Liquidity glut leads to artificially tight spreads and high valuations. This sends incorrect signals to real economy operators. In search of returns, lenders misprice risk. This leads to too much debt creation with not enough collateral value. Disequilibria and asset bubbles result.19
U.S. M&A transaction value bn, 60-day moving avgTighter spreads drove transaction volume to cyclicalhighs141210 Like residential real estate, the M&A wave appearsto have collapsed under its own weight. In both cases, it was lenders’ confidence thatdisappeared—not 6Jan-08Note: 60-day average of announced M&A deals (sum of mergers,acquisitions, divestitures, self-tenders, and spinoffs).Source: Bloomberg; data through January 11, 2008.The Fed’s global reachShare ofU.S. TradeDeficit ‘07CurrencyRegimeShare ofNon-U.S.Global y’s discussions of the appropriateness of Fedpolicy do not reflect the Fed’s global reach.TheFed heavily influences monetary policy for much ofthe world by virtue of pervasive managed currencyregimesVenezuela3.2%pegged0.5% Saudi Arabia2.9%pegged1.0%Global GDP is about 48tr and the U.S. makes upabout 13tr % Russia1.6%managed2.8%Together, the U.S. and countries that “shadow” thedollar represent nearly 40% of global GDP.India1.5%managed2.5% 1.5%managedWhile many countries are dramatically different fromthe U.S. and need their own policy mechanisms,mercantilist proclivities leave them constrained bygeneric managed currency regimes. All else being equal, rates are too low, and growthis too hot and not in equilibrium.CountryAngola50.4%0.1%15.6%Note: Trade deficit through 2Q07; GDP as of 2006, current US .Source: International Monetary Fund; International TradeAdministration / Commerce Department.U.S. trade position with Europe, Canada, OPEC, ChinaUS Dollar% Nov 06/Nov 07Trade deficit% Nov 06/Nov 07 / Euro(10.50%)(7.70%) / Canada(12.50%)(11.90%) / China(5.50%)11.50% / OPEC0.00%12.10%When markets are free to set policy based onfundamentals, things tend to balance The U.S. trade position with Europe and Canadahas improved as the dollar weakened, as one wouldexpect. However, when a currency is pegged to the dollar,trade balances are not allowed to correct andthings can even get worse, such as with China andOPEC.Note: Dollar change is November month-end; trade deficit is 12months ending November.Source: Commerce Department; Bloomberg.20
International reserve assets excluding gold (world) trillionLarge and growing capital flows to developingcountries are largely the result of undervaluedcurrencies6.506.005.505.004.50 Ongoing trade deficits that are not allowed to selfcorrect lead to massive build-ups of official foreigncurrency reserves. Global FX reserves have grown 168% since January2003 compared to global GDP, which has grown byabout 20% over the same time. In addition, sovereign wealth funds (SWFs) areconservatively estimated to have about 2tr– 2.5trin assets and are rapidly growing—assuming SWFassets get levered, it is clear SWFs will become veryinfluential on markets (see appendix, page n-07Source: Bloomberg; data through January 11, 2008.Comparative returnsWhen will it end?% y-o-y70 So far, strong global growth, led by explodingliquidity has continued, while the U.S. financialsector has tried to feel for a bottom. Blue chip emerging market stocks (shown byIShares-EMG on the graph, ticker EEM) demonstratethis. Ultimately, the question is whether the globalliquidity dynamic is so great that the growing U.S.financial “crisis” can unfold in a vacuum.503010-10-30Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07IShares-EMGS&P 500 indexSPDR-FINL selectNote: EEM holds about 300 stocks from emerging market countriesand seeks to provide results corres
How does global liquidity play into this? 19 U.S. M&A transaction value 20 The Fed's global reach 20 U.S. trade position with Europe, Canada, OPEC, China 20 International reserve assets excluding gold (world) 21 Comparative returns 21 #1 Gold bubble (gold spot prices) 22 #2 Tech bubble (Nasdaq composite index - CCMP) 22 #3 Housing bubble (S&P super composite
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