For an extraordinary week, the Dow gyrated wildly to a gain of 0.4% (up 6.2% y-t-d). The S&P500 gained 1.4%, increasing 2007 gains to 2.5%. The Transports jumped 1.8% (up 8.8%), and the Utilities surged 4.3% (up 6.0%). The Morgan Stanley Cyclical index dipped 0.6% (up 13.1%), while the Morgan Stanley Consumer index jumped 1.8% (up 2.6%). The broader market rallied – in many cases dramatically. The small cap Russell 2000 jumped 4.4% (up 0.1%), and the S&P400 Mid-Cap index gained 1.3% (up 5.9%). The NASDAQ100 added 0.3% (up 9.6%), and the Morgan Stanley High Tech index gained 0.5% (up 9.3%). The Semiconductors jumped 3.4% (up 7.8%). The Street.com Internet Index rose 1.4% (up 9.1%), and the NASDAQ Telecommunications index gained 0.8% (up 12.4%). The Biotechs rallied 1.5% (up 0.8%). The Broker/Dealers gained 2.8% (down 8.9%), and the Banks rallied 4.0% (down 9.9%). The HUI gold index recovered 1.9% (up 2.3%)
Two-year U.S. government yields this week added 3.5 bps to 4.46%. Five-year yields jumped 10 bps to 4.49%. Ten-year Treasury yields rose 11 bps to 4.80%. Long-bond yields ended the week a notable 16 bps higher to 4.80%. The 2yr/10yr spread ended the week at 34 bps. The implied yield on 3-month December ’07 Eurodollars declined 6 bps to 4.925%. Benchmark Fannie Mae MBS yields rose 7 bps to 6.18%, this week recovering a little of recent relative poor performance. The spread on Fannie’s 5% 2017 note narrowed one to 62, and the spread on Freddie’s 5% 2017 note narrowed one to 61. The 10-year dollar swap spread declined 3 to 71. Corporate bond spreads moved wildly, with the spread on a junk index ending the week a few bps narrower.
Credit Market Dislocation Watch:
August 10 – Financial Times (Gillian Tett, Richard Milne and Krishna Guha): “European Central Bank scrambled to head off a potential financial crisis yesterday by making an emergency injection of €94.8bn ($130bn) worth of funds into the region’s money markets, after signs that liquidity was drying up. The level of funds markedly exceeded the ECB’s only previous major intervention - on the day after 9/11 when it lent €69bn… Even more striking was its one-day pledge to meet 100% of all funding requests from financial institutions. This liquidity injection was designed to ensure that money markets continued to function and did not succumb to a credit freeze… The ECB did not offer any detailed explanation for its move, which caught markets by surprise, but simply said it was now seeking to ‘assure orderly conditions in the euro money market’… Marc Ostwald, fixed income strategist at Insinger de Beaufort, said: ‘There is huge pressure on money rates due to an apparent sense of mistrust. Following BNP Paribas’ statement, very few institutions appear willing to lend. If you kill off the inter-bank market and the asset- backed commercial paper market has effectively collapsed, then we look to be heading for a serious liquidity crunch.’”
August 10 – Financial Times (Gillian Tett ): “In recent weeks, traders in the credit world have repeatedly warned that a nasty liquidity crunch was developing in some rarefied financial corners, such as complex securities linked to mortgages. Yesterday, however, these liquidity concerns finally moved out of arenas beloved by financial nerds - and burst on to centre stage. In a move that startled the markets, the European Central Bank declared that it was ready to provide unlimited liquidity to banks, via its money market operations…. By some measures, the magnitude of the liquidity injection yesterday exceeded what the Federal Reserve did immediately after September 11 2001. However, what is perhaps most remarkable of all is that there initially seemed to be relatively little news yesterday morning that might, at face value, justify these crisis measures… One explanation - and the one alarming many traders - is that there is something truly nasty lurking out there in relation to credit losses that only the ECB knows about. If so, let us all pray that it does not involve any of the big dealer banks… In normal, happier, circumstances the operations of this CP market are ignored by non-specialists, since they are technical and opaque. However, the CP market plays a crucial role in the financial system, since it is where banks and other investment vehicles normally raise funds. In recent days, it appears that some CP investors have quietly stopped funding various investment vehicles, such as structured investment vehicles linked to European banks that hold asset-backed securities.”
August 10 – Bloomberg (Alexis Xydias): “The turmoil in the equity and credit markets has created a ‘perfect storm’ that led to losses for hedge funds employing mathematical strategies, according to a Citigroup Inc. strategist. Most quantitative strategies, such as investing solely on the basis of share value or changes in analysts’ earnings estimates, are resulting in declines, Manolis Liodakis, a London-based strategist at Citigroup, wrote in a report dated yesterday. The event is rare in an environment where volatility has increased. ‘Nothing seems to be working,’ Liodakis wrote. ‘Previously uncorrelated factors have recently been falling with the same pace, leaving investors with very few places to hide.’”
August 9 – Financial Times: “BNP Paribas became the latest European casualty of the fallout from the meltdown in the US subprime mortgage market after announcing it had suspended three of its funds because of jitters among its investors. The French bank said in a statement that the decision to suspend Parvest Dynamic ABS, BNP Paribas ABS Euribor and BNP Paribas ABS Eonia funds followed the ‘complete evaporation’ of liquidity. It said the valuation of the funds would resume as soon as liquidity returned to the market…according to Bloomberg data had about €2bn ($2.8bn) of assets at the end of last month, including €700m of exposure to US subprime mortgages rated AA or higher.”
August 9 – The Wall Street Journal (Karen Richardson and David Reilly): “Few parts of the capital markets, it seems, are immune from the problems posed by mortgages extended to risky borrowers -- even the usually staid world of money-market funds… The funds tend to invest in certificates of deposit and commercial paper, which are short-term notes either issued by companies or backed by assets such as inventories or loans. But some commercial paper may be fairly racy, containing mortgage-backed securities that could include chancy subprime loans. That isn’t likely to cause big losses at these funds or endanger them. Still, it is prompting money-market managers to pay closer attention to what is backing the commercial paper they buy, demand additional compensation for investing in a particular type of vehicle that issues some asset-backed commercial paper and call for greater transparency in this market. That, in turn, is bringing a greater focus to bear on so-called conduits. These vehicles issue asset-backed commercial paper and potentially allow banks and other financial institutions to push risky loans off their books. Asset-backed commercial paper accounts for about half the $2.2 trillion commercial-paper market.”
August 7 – Dow Jones (Anusha Shrivastava ): “The investment-grade corporate bond market has ground to a halt, making it difficult for companies to access capital and hard for investors to find a place to put their money to work. The problems in the high-grade market, which caters to companies with solid credit rankings, come amid turmoil in stock and high-yield bond and loan markets as investors, spooked by the troubles in the subprime mortgage market, turn their backs on risky assets. It amounts to a major repricing of risk after years of skimpy returns and low volatility. ‘The market is just frozen up,’ said Jim Cusser, a portfolio manager at Waddell & Reed…”
August 7 – Bloomberg (Darrell Hassler): “Global sales of collateralized debt obligations totaled $36.1 billion in July, a 35% decline from June, as losses mounted on subprime mortgage bonds, according to Morgan Stanley. Sales were the lowest since January. CDOs backed by highly rated mortgage securities fell to $1.5 billion last month, a drop of 85%, Morgan Stanley analyst Vishwanath Tirupattur…said…”
August 10 – The Wall Street Journal (Dana Cimilluca and Dennis K. Berman): “Choking on a massive backlog of pending private-equity financings and a choppy credit market, investment banks are rapidly retreating from offers to finance other deals in the works. In a slew of recent auctions, investment banks have yanked back so-called stapled-financing packages used by sellers' banks to attract private-equity bidders. The seller-financing is called ‘staple’ financing because it is often physically "stapled" to offering documents. The deals number at least five and include Morgan Stanley's sale of cable company Insight Communications Co. and Goldman Sachs Group Inc.'s sale of Goodman Global Inc., a Houston-based maker of heating products that is part owned by private-equity firm Apollo Management LP.”
August 9 – Bloomberg (Gabi Thesing): “A slowdown in the European leveraged buyout market could pose a ‘substantial’ risk to European financial stability and hit the banking sector ‘in several phases, the European Central Bank warned today. ‘While banks’ direct debt exposure to LBO transactions appears limited given that most debt is disposed of via credit risk transfer instruments or securitization, the uncertainty about the identity of the final holders of LBO credit risk that is being distributed is substantial…”
Investment grade debt issuers included Merrill Lynch $2.75bn, IBM $2.6bn, Kraft $2.5bn, Bank of America $2.0bn, Citigroup $4.5bn, Marshall & Ilsley $400 million, Wisconsin P&L $300 million, PPL Electric Utilities $250 million, Colonial Pipeline $250 million, and Private Export Funding $250 million.
No junk issuance again this week.
Convert issuers included AMD $1.5bn, Chesapeake Energy $500 million and Nuance Communications $250 million.
International dollar bond issuance this week included Gazprom $1.25bn, Encana $500 million and Ceva Group $400 million.
German 10-year bund yields increased 4 bps to 4.35%, while the DAX equities index declined 1.2% (up 11.3% y-t-d). Japanese 10-year “JGB” yields dropped 6 bps to 1.705%. The Nikkei 225 declined 1.3% (down 2.7% y-t-d). Emerging debt and equity markets were volatile and appearing increasingly susceptible. Brazil’s benchmark dollar bond yields dipped 2 bps this week to 6.13%. Brazil’s Bovespa equities index dipped 0.4% (up 18.4% y-t-d). The Mexican Bolsa declined 0.8% (up 11.2% y-t-d). Mexico’s 10-year $ yields declined one bp to 5.86%. Russia’s RTS equities index fell 3.7% (down 1.3% y-t-d). India’s Sensex equities index dropped 1.7% (up 7.8% y-t-d). China’s Shanghai Composite index ended the week up 4.1% to another record high (up 78% y-t-d and 196% over the past year).
Bank Credit surged $36.5bn (week of 8/1) to $8.683 TN (5-wk gain of $117bn). For the week, Securities Credit gained $5.2bn. Loans & Leases jumped $31.3bn to $6.365 TN. C&I loans rose $4.8bn, and Real Estate loans increased $7.0bn. Consumer loans declined $2.3bn. Securities loans gained $6.3bn, and Other loans rose $15.5bn. On the liability side, (previous M3) Large Time Deposits surged a notable $30.9bn.
M2 (narrow) “money” expanded $10.6bn to $7.283 TN (week of 7/30). Narrow “money” has expanded $240bn y-t-d, or 5.7% annualized, and $449bn, or 6.6%, over the past year. For the week, Currency increased $1.0bn, while Demand & Checkable Deposits rose $10.7bn. Savings Deposits slipped $1.5bn, and Small Denominated Deposits declined $1.0bn. Retail Money Fund assets increased $1.5bn.
Total Money Market Fund Assets (from Invest. Co Inst) surged $50.2bn last week (2-wk gain of $73.4bn) to a record $2.657 TN. Money Fund Assets have increased $275bn y-t-d, a 18.8% rate, and $481bn over 52 weeks, or 22.1%.
Total Commercial Paper jumped $10.8bn last week to $2.224 TN, with a y-t-d gain of $249bn (20.5% annualized). CP has increased $429bn, or 23.9%, over the past 52 weeks.
Fed Foreign Holdings of Treasury, Agency Debt last week (ended 8/7) declined $3.5bn to a record $2.006 TN. “Custody holdings” were up $254bn y-t-d (23.6% annualized) and $344bn during the past year, or 20.7%. Federal Reserve Credit last week fell $7.0bn to $850.6bn. Fed Credit has declined $1.7bn y-t-d, with one-year growth of $25.4bn (3.1%).
International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $867bn y-t-d (29.3% annualized) and $1.097 TN y-o-y (24%) to a record $5.667 TN.
The spot dollar index rallied 0.6% to 80.68. On the upside, the Canadian dollar increased 0.4%. On the downside, the Thai baht declined 4.8%, the Brazilian real 2.6%, the Iceland krona 2.6%, the New Zealand dollar 2.0%, and the Australian dollar 1.2%. The Japanese yen slipped 0.3% and the Euro 0.6%.
August 6 – Financial Times (Javier Blas): “The cost of shipping dry bulk commodities, such as coal, iron ore and cereals, has surged to a new high boosted by strong demand, port congestion and a significant lengthening of trade routes. The Baltic Dry Index, the best gauge of the world’s dry bulk shipping costs, last week rose above 7,000 points for the first time - an increase of 103% in the past year. The index…has jumped almost fivefold since 2000. The sharp increase threatens to add to already rising prices for agriculture, base metals and ore commodities.”
August 8 – Bloomberg (Tony C. Dreibus): “Wheat rose, extending a rally to a record in Chicago, on speculation that demand for U.S. grain will climb because of unfavorable weather for crops in Europe and Canada. The harvests in parts of England, France and Germany have been delayed by wet weather… Canada, the world’s third-largest exporter, may produce 12% less wheat in the year ending July 31… ‘The U.S. is the only one who has wheat, and everybody needs it,’ said Tomm Pfitzenmaier, a partner at Summit Commodity Brokerage… ‘Russia and Europe don’t have much to sell.’ Wheat futures for December delivery climbed… 2.7 %, to $7.01 a bushel… The price has surged 83% in the past year…”
August 8 – Bloomberg (William Bi): “China’s soybean imports, the world’s biggest, may rise to a record next year as drought in the main growing region threatens to worsen a decline in output caused by reduced planting. Imports in the year through September 2008 are likely to jump 11%...”
For the week, Gold was little changed at $672.60, while Silver fell 2.2% to $12.87. Copper dropped 3.4%. September crude sank $3.80 to $71.68. September gasoline fell 3.7%, while September Natural Gas surged 12%. For the week, the CRB index declined 2.3% (up 1.2% y-t-d), and the Goldman Sachs Commodities Index (GSCI) dropped 2.7% (up 12.9% y-t-d).
August 7 – Bloomberg (Kathleen Chu): “Land prices in parts of central Tokyo last year reached comparable levels to 1991, when nationwide land prices peaked, indicating the possibility of a ‘mini bubble,’ Mizuho Research Institute said… Mizuho estimated that the most expensive 5% of land in Tokyo’s 23 wards averaged 33.7 million yen ($283,861) per square meter in 2006… That was greater than the average of 31 million yen per square meter in 1991, the institute said.”
August 10 – Bloomberg (Kathleen Chu): “Tokyo office rents rose in the second quarter to the highest in 13 years because of a lack of supply and strong demand generated by Japan’s growing economy, Jones Lang LaSalle Inc. said. Average monthly rents for grade A office buildings advanced 6.2% from the first quarter…”
August 10 – Bloomberg (Nipa Piboontanasawat): “China’s trade surplus surged 67% in July to the second-highest on record, bolstering U.S. Treasury Secretary Henry Paulson's case for a faster appreciation of the yuan. The gap widened to $24.4 billion from $14.6 billion a year Earlier…”
August 10 – Bloomberg (Nipa Piboontanasawat): “China’s money supply grew at the fastest pace in more than a year as the trade surplus surged, adding pressure on the government to allow faster yuan gains. M2… rose 18.5% in July from a year earlier…”
August 8 – Market News International: “Chinese inflationary pressures are increasing and may not ease in the short-term, the People’s Bank of China warned in its second quarter monetary policy report… The central bank also noted that the trend towards economic overheating is becoming more apparent, reiterating the government commitment to ‘moderately tighten monetary policy. It noted the difficulties in bringing down meat and grain price inflation in the short-term and said that it remains on guard to watch if food price inflation spills out into other consumer goods.”
August 8 – Bloomberg (Zhang Dingmin and Nipa Piboontanasawat): “China faces the risk of faster inflation as food and labor costs rise, the central bank said. The economy is shifting toward becoming overheated, the People’s Bank of China said… The bank will need ‘new instruments’ to soak up excess liquidity, the central bank said…”
August 9 – Bloomberg (Christina Soon): “China should consider using its $1.33 trillion currency reserves as a ‘bargaining chip,’ after some U.S. senators threatened trade sanctions on Chinese imports unless the yuan appreciates, a government researcher said. ‘Using them as a bargaining chip isn’t something that can’t be considered in response to some silly U.S. senators,’ Xia Bin, director of financial research at the State Council Development Research Center, said…”
August 8 – Bloomberg (Jake Lee): “China’s $1.33 trillion foreign-exchange reserves are becoming a political tool in trade negotiations with the U.S., said Simon Derrick, Bank of New York’s chief currency strategist. China, the largest holder of U.S. Treasuries after Japan with $407 billion, plans to invest in other securities as it sets up an agency to boost returns on its investments. China should use reserves as a ‘bargaining chip’ with foreign governments, Market News cited a government researcher as saying…”
August 8 – Bloomberg (Laurie Burkitt): “Rents in Hong Kong’s central business district will probably rise 10% this year because of a shortage of office space, according to property agency CB Richard Ellis Group Inc. The first-half vacancy rate in the city’s prime office market in Central reached a historical low of 2.2%...”
August 10 – Bloomberg (Cherian Thomas): “India’s industrial production grew in June at the slowest pace in eight months, below all estimates, as interest rates at a five-year high curbed consumer spending. Production at factories, utilities and mines rose 9.8% from a year earlier…”
Unbalanced Global Economy Watch:
August 8 – Bloomberg (Simone Meier): “Exports from Germany, Europe’s largest economy, rose the most in eight months in June, suggesting faster global economic growth is helping companies weather the euro’s appreciation…. From a year ago, exports rose 11.9%.”
August 7 - Dow Jones: “The Bank of Spain Monday said gross domestic product grew around 4% in the second quarter, according to its latest estimates, compared with the 4.1% in the first quarter.”
August 6 – Bloomberg (Robin Wigglesworth): “Norway’s jobless rate fell to 2.5% in the three months through June from the month-earlier period as companies struggled to find skilled workers, increasing pressure on the central bank to raise interest rates.”
August 9 – Bloomberg (Robin Wigglesworth): “Norwegian retail sales growth accelerated to an annual 11.9% in June, the highest in at least 27 years, as higher salaries and increased employment fueled a spending boom.”
August 7 – Bloomberg (Ellen Pinchuk): “Russian money supply, boosted by revenue from crude oil sales, is growing quickly and creating inflationary pressure, Finance Minister Alexei Kudrin said. The money supply increased 51% by Aug. 1 from Aug. 1 of last year… ‘Currently, Russia has a very large inflow of capital into the country’…”
August 9 – Bloomberg (Tracy Withers): “New Zealand’s jobless rate fell to an all-time low in the second quarter… The jobless rate dropped to 3.6% from 3.7% in the first quarter…”
Bubble Economy Watch:
August 6 – Financial Times (Christopher Bowe): “Bad debts at hospitals from unpaid patient bills are triggering deep and growing problems within the US healthcare system as up-front costs are increasingly passed on to consumers and growing numbers of people are opting out of health insurance. Bad debts for hospitals in 2004 were estimated to be between $26bn and $30bn, and currently represent about 12% of hospitals’ revenue and rising.”
Central Banker Watch:
August 9 – Bloomberg (Christian Vits): “The Bundesbank said German banks created a ‘banking pool’ to back IKB Deutsche Industriebank AG, the German bank facing a bailout over subprime mortgage losses. ‘The meeting of representatives of German banks at the Bundesbank was about details and the contractual implementation of a risk-coverage package for IKB,’ the Bundesbank said… ‘The KfW was appointed to lead the pool.’ Germany’s state-owned KfW Group and banking associations agreed to cover as much as 3.5 billion euros ($4.8 billion) of potential losses at IKB.”
August 8 – Bloomberg (Victoria Batchelor and Gemma Daley): “Australia’s central bank raised its benchmark interest rate a quarter point to the highest in almost 11 years… Governor Glenn Stevens raised the overnight cash rate target to 6.5% today in Sydney…”
August 8 – Bloomberg (Brian Swint): “Bank of England forecasts suggest one more interest-rate increase will be needed to bring inflation back to target in two years. ‘Indicators of pricing and capacity pressures remain particularly important,’ Governor Mervyn King said… ‘If they do not fall back, that would be consistent with the upside risks to inflation crystallizing.’”
August 6 – Financial Times: “Those hoping that the ‘Greenspan put’ lives on in his successor are likely to be disappointed. Ben Bernanke, chairman of the Federal Reserve, has made pretty clear in the past that he does not plan to ride in with interest rate cuts to save the markets from themselves. Instead the Fed will take its decisions based on the economic data. Recent turmoil in the credit markets, which stemmed from problems with subprime mortgages and has caused serious stock market jitters, is therefore unlikely to get Mr Bernanke pulling the trigger.”
Financial Sphere Bubble Watch:
August 8 – Financial Times (Michael Mackenzie and Saskia Scholtes): “Fears of a credit crunch have triggered a surge in trading volumes for one of Wall Street’s more recent innovations - derivative index contracts that enable big investors to protect themselves against defaults or boost risk-taking. Daily trading volumes for the US CDX investment grade index hit a peak of $221bn last week… The index represents a basket of credit derivatives based on the ratings of 125 investment grade companies. The trading volumes in the US CDX have soared from an average of about $30bn since mid-June as the cost of buying credit insurance on the index has more than doubled… Hedge funds and even hitherto reticent money managers quickly warmed to the benefit of being able to buy and sell a diversified pool of credit risk quickly and easily.”
August 8 – Financial Times (Norma Cohen ): “Turbulent markets in July produced record trading volumes on stock exchanges in the US and Europe… The London Stock Ex-change...reported a record high in trading volumes on its electronic trading platform in July, which rose 96% over those of the previous year to 12.1m trades. NYSE Euronext said European equities trading rose 79.4% in July to 1.2m trades while its US arm saw a rise of 78.9% in its share trading volumes.”
April 10 – Bloomberg (James Tyson): “Fannie Mae and Freddie Mac, the largest U.S. mortgage finance companies, are far from completing the bookkeeping and governance changes that were prompted four years ago by what amounted to $11.3 billion in accounting errors, their regulator said in its annual report to Congress. The companies should be able to complete the remediation within the next two years, James Lockhart, director of the Office of Federal Housing Enterprise Oversight, told reporters in Washington after releasing the report. ‘I would think they would have failed if they haven’t fixed it in two years.’ Ofheo’s report cited ‘extensive deficiencies’ in Fannie Mae’s ability to measure risk, and inconsistent progress at Freddie Mac in improving controls. Ofheo, Congress and the Bush administration have compelled the companies, which guarantee or own about 40% of the nation’s $10.5 trillion residential mortgage market, to improve accounting and governance in order to reduce the risk posed to market stability.”
April 12 – Bloomberg (James Tyson): “Fannie Mae and Freddie Mac, the largest sources of money for U.S. home loans, would be forced to sell 70% of their combined $1.4 trillion in mortgage assets under legislation introduced today by four Republican Senators on the panel that oversees the companies. The government-chartered companies could only hold mortgages and mortgage bonds that promote homeownership among low-income Americans, according to the legislation introduced by Senators Chuck Hagel of Nebraska, John Sununu of New Hampshire, Elizabeth Dole of North Carolina and Mel Martinez of Florida.”
Mortgage Finance Bubble Watch:
August 10 – Bloomberg (Steve Dickson): “Countrywide Financial Corp., the biggest U.S. mortgage lender, said it faces ``unprecedented disruptions'' that may crimp profit, suggesting a credit crunch that started with the U.S. subprime market will spread…. Countrywide won't be able to sell as many of its loans as expected because investor demand has dried up, the…company said… It also said it may have difficulty obtaining financing from creditors.”
August 9 – Financial Times (David Wighton, Saskia Scholtes and Michael Mackenzie): “Large parts of the stricken US mortgage market are facing further tightening in the supply of credit following the collapse of dozens of lenders and a buyers’ strike by investors in mortgage-backed securities. Falling Treasury yields in recent weeks have led to lower interest rates on standard mortgages. But for larger and less creditworthy new borrowers loans have become more expensive and harder to obtain. Some types of borrowers can no longer get a loan from a mainstream lender at any price and the prospect of rate cuts by the Federal Reserve may bring little respite.”
August 8 – Bloomberg (Jody Shenn): “Financing terms for non-agency mortgage bonds have gotten ‘massively’ tighter in the past three months because of hedge-fund losses, according to UBS AG. Financing for AAA rated non-agency mortgage securities now typically requires ‘haircuts’ of 7% to 10%, up from 3% to 5% in May… analysts at
UBS led by Laurie Goodman wrote… A haircut represents how much a fund or company must buy with its own money when financing holdings with debt and cash. A 5% haircut equals 20 times leverage.”
August 8 – The Wall Street Journal (James R. Hagerty): “The mortgage-market meltdown isn’t over, but it already has produced two clear winners: Fannie Mae and Freddie Mac, the nation’s biggest investors in home loans. Until recently, politicians in Washington were arguing about how best to rein in the two giant government-sponsored companies, both recovering from accounting scandals and lapses in financial controls. Now, as worry about the housing market trumps accounting scruples, the political debate has shifted to whether Fannie and Freddie need to grow even bigger to buy more loans and calm mortgage investors. Sen. Christopher Dodd (D., Conn.), chairman of the Senate Banking Committee, yesterday called on the companies’ regulator to consider raising the caps placed last year on the amount of mortgages and related securities Fannie and Freddie can hold… Sen. Charles Schumer (D., N.Y.) also called for higher caps. Both Fannie and Freddie are pushing for the same move.”
MBS/ABS/CDO/CP/Money Funds and Derivatives Watch:
August 10 – Bloomberg (David Clarke): “The assets of Deutsche Bank AG’s DWS ABS Fund fell by a third to 2.1 billion euros ($2.9 billion) from 3 billion euros at the end of July, as the fund’s investments lost value and clients withdrew money.”
August 8 – Bloomberg (Mark Pittman and Elizabeth Stanton): “Companies are extending payments on commercial paper backed by home loans for the first time as the subprime mortgage crisis spreads to debt perceived to be among the safest in the market, according to Moody’s… Units of American Home Mortgage Investment Corp., the residential-mortgage lender that filed for bankruptcy, Luminent Mortgage Capital Inc., facing margin calls from lenders, and Aladdin Capital Management LLC, this week exercised an option allowing them to delay repaying the debt… The three issuers are probably the only ones to defer payments since extendible asset-backed commercial paper was first sold 12 years ago… The failure of some companies to pay on time has cast a pall over the securities, which are considered to be almost risk free, said Lee Epstein, chief executive officer of Money Market One. ‘The subprime tsunami has come to the beach, as it were, to the safest of the safe,’ Epstein said…”
August 8 – The Wall Street Journal (Kemba J. Dunham): “As the credit markets continue to tighten, real-estate investment trusts that specialize in home loans are particularly vulnerable. Yesterday, Impac Mortgage Holdings Inc… said…that it will cease funding ‘Alt-A’ mortgages…”
Real Estate Bubbles Watch:
August 8 – Bloomberg (Kathleen M. Howley): “U.S. home sales will tumble to a five-year low this year as the widening credit crunch reduces the number of buyers who can get mortgages, the National Association of Realtors said today. The group lowered its outlook for the eighth time this year and said sales of previously owned homes probably will fall 6.8% to 6.04 million in 2007, the lowest since 2002. New-home sales…probably will fall 19% to 852,000, a 10-year low. ‘Mortgage disruptions will hold back sales over the short term,’ Lawrence Yun, an economist for the group, said…”
M&A and Private-Equity Bubble Watch:
August 10 – Bloomberg (Jason Kelly and Ambereen Choudhury): “The global stock-market decline dented shares of buyout targets including TXU Corp., SLM Corp. and First Data Corp., prompting speculation some deals may go back to the negotiating table. Private-equity firms that said they would pay high premiums based on cheap debt and guaranteed financing are revising terms.”
Energy Boom and Crude Liquidity Watch:
August 8 – Bloomberg (Maria Levitov): “Russia increased its imports from countries outside of the former Soviet Union in the first seven months of the year as economic expansion boosted incomes and spending, the Federal Customs Service said. Russia’s imports totaled $85.63 billion from January through July, a 50% increase from the year-earlier period… Russia, the world’s biggest energy exporter, has entered its ninth consecutive year of economic expansion, which boosted incomes and spending.”
August 9 – Financial Times (Mark Turner): “The world this year has suffered record-breaking weather extremes in almost every continent, the United Nation’s World Meteorological Organisation has warned, with global land temperatures reaching their highest levels since records began in 1800. The floods, droughts, heatwaves and storms could be part of the climate’s natural variations and cannot be directly attributed to climate change. However, such instances of extreme weather are consistent with predictions of what will happen as the world’s climate grows warmer… Experts from the Intergovernmental Group on Climate Change have said the process would become irreversible if temperatures rise 3°C above pre-industrial levels. The WMO said global land surface temperatures in 2007 were 1.89°C warmer than average for January, and 1.37°C warmer than average for April. It tracked an alarming incidence of unusually adverse weather from Europe and Asia to Latin America, the Middle East and Africa.”
August 10 – Bloomberg (Katherine Burton): “James Simons’s $29 billion Renaissance Institutional Equities Fund has fallen 8.7% so far in August as his computer models used to buy and sell stocks were overwhelmed by securities’ price swings. The two-year-old quantitative, or ‘quant,’ hedge fund now has declined 7.4% for the year. Simons said other hedge funds have been forced to sell positions, short-circuiting statistical models based on the relationships among securities.”
August 10 – Bloomberg (Katherine Burton and Jenny Strasburg ): “Goldman Sachs Group Inc.’s $8 billion Global Alpha hedge fund has fallen 26% so far this year, according to people familiar with the fund.”
August 9 – The Wall Street Journal (Henny Sender and Kate Kelly): “Computers don’t always work. That was the lesson so far this month for many so-called quant hedge funds, whose trading is dictated by complex computer programs. The markets’ volatility of the past few weeks has taken a toll on many widely known funds for sophisticated investors, notably a once-highflying hedge fund at Wall Street's Goldman Sachs Group Inc. Global Alpha, Goldman’s widely known internal hedge fund, is now down about 16% for the year after a choppy July, when its performance fell about 8%, according to people briefed on the matter. The fund…manages about $9 billion… Campbell & Co., an $11 billion hedge fund that trades in the futures market as well as in stocks and bonds and is completely driven by such computer programs, was down 10% to 12% by the end of July. Quant funds – ‘quant’ stands for quantitative -- generally operate by building computer models of market behavior and then allowing the computer programs to dictate trading. A recurring characteristic of the recent trouble in financial markets is that many lenders, funds and brokerages were following statistical models that grossly underestimated how risky the market environment had become. ‘Our risk models failed to pick up the fact that we were due for a correction,’ says Keith Campbell, founder of Campbell & Co. ‘We were highly diversified. It was the perfect negative storm.’”
August 10 – Financial Times (Michiyo Nakamoto): “Japan’s financial regulator, the Securities and Ex-change Surveillance Commission, is concerned that the growing influence of hedge funds is encouraging insider trading and undermining the integrity of the country's stock markets. ‘We believe there is [a] risk . . .that hedge fund managers are involved in market misconduct . . . such as insider trading based on information obtained from prime brokers, or market manipulation,’ says Kiyotaka Sasaki, director of strategy and policy co-ordination at the SESC. ‘Investment banks can’t survive unless they do business with hedge funds. The relationship between investment banks and hedge funds is too close.’”
A Run on Wall Street Finance:
The market week commenced with the fanciful notion that increased purchases by the GSEs would suffice to re-liquefy the U.S. mortgage marketplace. The NYSE Financial Index proceeded to rally 7% before reality began to return Wednesday afternoon. A tumultuous week of faltering international Credit markets ended with the major global central banks injecting liquidity to the tune of $140bn, including Federal Reserve mortgage-backed securities purchases of $38bn. This afternoon it was reported that Fannie Mae sought permission for asset growth of “a moderate increase in the range of 10 percent” – a $70bn or so drop in the bucket.
The GSEs will certainly not be bailing out the global Credit system. Instead, the question has become how successful global central bankers will be in restoring confidence in a system that so has so abruptly begun coming apart at the seams. At this point, I will assume that global central bankers have come to accept that only their aggressive interventions offer the hope of a liquidity backstop sufficient to bolster fading confidence and stem a modern-day Run on “Wall Street Finance.”
The Risk Market Contagion that erupted in U.S. subprime mortgages has now fully engulfed the heart of “structured finance” – the CDO marketplace, asset-backed securities, the “repo” market, Credit derivatives, “structured products,” and even the perceived pristine “money” market fund complex. The cover story from today’s Financial Times (see above) quoted Marc Ostwald, fixed income strategist at Insinger de Beaufort: “There is huge pressure on money rates due to an apparent sense of mistrust. Following BNP Paribas’ statement, very few institutions appear willing to lend. If you kill off the inter-bank market and the asset- backed commercial paper market has effectively collapsed, then we look to be heading for a serious liquidity crunch.”
Central banks do retain significant potential firepower to buttress marketplace liquidity in the near-term. Yet the ongoing impact such interventions will have in restoring trust in market pricing, securities ratings, sophisticated model-based and leveraged trading strategies, counterparty risk, general risk management/hedging capabilities, and liquidity in Wall Street’s newfangled “structured” products is very much an open question. It is my view that some Crucial Financial Myths have been Thoroughly DisCredited.
I have often addressed the notion of the “Moneyness of Credit” – in particular, the vital role played by what had been the prevailing Credit market perception that myriad debt instruments were both a store of nominal value (“safe”) and readily marketable (“liquid”). In general, a market’s belief that Credit is as attractive (holds similar attributes) as “money” plays a decisive role in fostering Credit expansion. Over time, as the perception of moneyness is applied to expanding types and quantities of Credit instruments, a full-fledged Credit Bubble takes hold. And, as we’ve witnessed, the longer Credit excesses inflate asset prices, corporate earnings, and household incomes - the more seductive the Myth that the underlying Credit instruments are increasingly safe and liquid.
It takes years (decades?) and, importantly, the successful perseverance through at least a few close calls, for the Perception of Moneyness to become fully embedded in the structure of the Credit system. Emboldened market participants eventually come to believe that that nothing can seriously interrupt the boom. Each near crisis surmounted leads to only greater confidence in the underlying Credit system and the capacity for the authorities to sustain the expansion - each period of greater excess layers more dangerous layers of risk on top of an increasingly fragile pyramid of risk.
Last week I discussed the previous (unsung) hero role the GSEs played in multiple near financial crises going back to 1994. Whether they acted in concert or not, timely Fed rate cuts coupled with huge GSE market purchase operations provided an epic market support mechanism throughout a period of unprecedented Wall Street innovation and enlargement. The powerful (and epic) process of expanding Moneyness of Wall Street Credit is beholden to the Fed and GSEs.
Importantly, over time the market perceived that liquidity could be taken for granted under virtually all circumstances. Clearly, any “AAA” security would remain highly liquid – even during those occasional (and brief) bouts of market turbulence. “Triple A” came to connote “money” – an instrument that would always entice a buyer at a fair market price. Better yet, often such instruments even increased in value during market tumult. It certainly didn’t hurt that GSE debt dominated the entire “AAA” market – their short- and long-term debt instruments as well as agency MBS equipped with their guarantees. And as the leveraged speculators repeatedly took full advantage – certainly in 1994, 1998, 1999 and 2000 - the GSEs were more than happy to pay top dollar or more for MBS, mortgages, and other debt instruments any time the progressively over-leveraged markets lurched toward de-leveraging and illiquidity.
Administrations, Congresses, and the Fed took no issue with the marketplace’s implied government backing of GSE debt, allowing the GSEs for years to luxuriate in their unlimited access to market-based borrowings. Indeed, GSE debt enjoyed the extraordinary status of being completely immune to market liquidity concerns. The GSEs could borrow as much as they wanted – especially during periods of market tumult – and buy as much MBS and as many debt instruments in the marketplace as they (and the market!) desired. I can't stress too strongly how this profoundly distorted the markets’ perception of pricing and liquidity risk for agency debt as well as for the markets overall (especially "AAA"!) - and for years nurtured today's unfolding financial crisis.
But why do I this evening insist on rehashing the sordid history of GSE/Fed market interventions? Well, I am convinced they played the key role in the market’s momentous misperception that “AAA” stood for “Always And Anytime liquid.” For a decade, GSE-related debt instruments dominated “AAA” and anything associated with the GSEs was always highly-liquid even the most adverse market conditions. And this liquidity had very much to do with the extraordinary mechanism whereby, during periods of financial stress, eager buyers of GSE debt (especially foreign buyers) would provide the GSEs unlimited wherewithal to provide a Liquidity Backstop in MBS, mortgage, and mortgage company debt instruments.
Not only were the GSEs not susceptible to “Ponzi Finance” dynamics, these strange government-sponsored market operators evolved into the Anti-Ponzi. Whenever market confidence began to wane, “money” flooded into the GSEs and right out the door to the increasingly speculative markets – and everyone confidently enjoyed robust returns provided by an unparalleled and seemingly endless liquidity-generating machine. And, let there be no doubt, the sophisticated leveraged speculating community took complete advantage of this extraordinary liquidity backdrop. I really believe that if there had been no extended GSE boom – there would have been no Mortgage Finance Bubble – no Wall Street "Structured Finance" Bubble – no derivatives Bubble – and no protracted economic consumption-based U.S. economic boom. Unavoidable liquidity crisis would have nipped all in the bud some years ago.
Well, the world of finance subtly changed with the revelation of the GSEs’ (inevitable) Abuse of Phenomenal Financial Power. Issuance of GSE debt and Agency MBS stalled abruptly in 2004. Yet, by that time, Mortgage Finance Bubble Dynamics were in full force. After all, Inflationary Biases had taken firm hold in real estate markets across the country and, at least as signficant, throughout the expansive Wall Street mortgage finance apparatus. Indeed, the Street didn’t so much as miss a beat with the hamstrung GSEs. The evolution of market perceptions of Moneyness to include ALL mortgage-related securities had created the backdrop for an historic issuance boom in Wall Street “private-label” MBS and ABS (see charts above). The Perception of Moneyness encouraged the use of these higher-yielding securities in sophisticated vehicles and structures that became the investment and speculative vehicles of choice for hedge funds, international banks, Wall Street firms and investment funds around the world. An increasingly assertive Wall Street was quite keen to more than fill the GSE void with its own brand of top-rated "structured finance." And flood it they did.
The upshot were Bubbling markets for ARMs, jumbo, Alt-A, “teaser”, “exotic” and scores of subprime mortgages – the majority finding homes in the mushrooming market for Wall Street CDOs and other “structured products.” A protracted mortgage boom and inflated home prices provided a history of minimal Credit losses, emboldening those rating mortgage-related securities as well as those happy to take leveraged positions in these perceived money-like instruments (including the proliferation of hedge funds, mortgage REITs, Wall Street trading proprietary trading operations, etc.). While the GSEs were left to spend billions sorting through their accounting mess, the various Bubbles they were instrumental in nurturing grew to unfathomable dimensions. Never in history were so many “AAA” (and “AA”) securities being created, many sliced and diced from less than money-like mortgages. This mortgage debt explosion dispersed “top-rated” U.S. debt securities throughout the U.S. and global financial systems. Worse yet, this Wall Street Alchemy of transforming risky mortgage paper into perceived money-like securities worked so marvelously the industry moved immediately to do the same for risky acquisition-related finance and the unfolding Global M&A Bubble.
Returning back to the subtle change beginning back in 2004, the character of risk associated with new MBS issuance deteriorated markedly. While the “AAA” status remained constant, the non-GSE “private-label” variety of MBS/ABS were associated with increasingly risky underlying mortgages. The insatiable appetite for these relatively higher-yielding securities to satisfy the booming demand for CDOs and other structured products was sufficient to deaden any market sensitivity to the reality that the GSE liquidity backstop had been slammed shut. GSE balance sheets were no longer in a position to balloon on demand. Besides, most of these “private-label” securities were not within the charter of GSE purchases anyways. The marketplace might have been conditioned to believe liquidity risk had not changed – but it had and profoundly.
From the spectacular subprime implosion to this week’s rapidly unfolding global liquidity crisis, a clearer picture is emerging: It’s one of a momentous reversal in the liquidity backdrop from GSE-induced Anti-Ponzi to the Acute Financial Fragility associated with Minskian Ponzi Finance. No longer does a reversal in speculator leverage conveniently flow onto GSE balance sheets, setting the stage (with Fed rate cuts) for an only more egregious expansion of Credit and speculative excess. Instead, de-leveraging these days has quickly incited contagious marketplace illiquidity and a highly disruptive reversal of speculative flows from mortgage-related instruments, along with the very real risk of a mortgage Credit collapse and financial markets liquidity dislocation.
It is popular to explain market gyrations as a “re-pricing” of risk. Other comments suggest that this is only a “short-term Credit crunch” and that “this is a liquidity issue not a solvency issue.” This is much, much more serious. Key facets of “contemporary finance” are on the line. The entire process of Wall Street Credit and Risk Intermediation is today in jeopardy.
There are literally Trillions of dollars of impaired debt instruments – previously “top-rated” securities that will never live up to their (fallacious) billing. And after a spectacular multi-year issuance boom, they are everywhere - especially in places appropriate for only the most “money-like” instruments. The perceived safest and most liquid securities found homes in various types of “money market” funds and other perceived low-risk investment vehicles. The perceived safest and most liquid instruments were fodder for the greatest abuses of leverage. The bottom line is that these securities were misconceived as “money-like” from day one, and the marketplace has shifted to the recognition that they are instead highly risky and inappropriate for most investment vehicles, as well as for leveraged strategies. This radical change in market perceptions is wreaking bloody havoc on the untested Credit derivatives marketplace.
Global central banks can somewhat cushion the de-leveraging process, but I doubt they can do much more than slow the flight from risky Credit instruments and “investment” vehicles. Importantly, perilous market misperceptions with respect to risk and liquidity have been exposed. Speculative de-leveraging is unmasking serious flaws in various assumptions (including liquidity and market correlations) used by “black box” models in leveraged strategies across various securities markets. Risk management strategies are failing. The bloom is off the rose and a tidal wave of hedge fund withdrawals – and further de-leveraging - cannot be ruled out.
The major international banks have been key players in U.S. structured finance, especially in money market “conduits,” “funding corps,” and “special purpose vehicles.” This might very well be the epicenter of the current liquidity crisis, and they will surely vow to avoid such exposure to U.S. Credit risk going forward. The highly leveraged Wall Street firms will struggle to rein in risk on myriad fronts and likely be forced to fight mightily for survival. And for how long the American public can hold its nerve is a major question. They have been conditioned to believe that their holdings in the stock, bond, and “money” market are safe and secure. And the longer central bank interventions sustain unsustainably inflated asset markets, the greater the opportunity for the speculator community to “distribute” their holdings to the unsuspecting public.
As much as I recognize the traditional role of central banks as liquidity providers of last resort, I just sense that being forced to move this early – with global stock markets at near record highs – provides confirmation of the Acute Fragility of the global Credit system. Such moves would appear to risk further destabilizing already highly unstable global markets, especially currency markets. This does look to me as a Run on Wall Street Finance – and an absolute mess.