Due to system upgrade requirements, I was forced to rush my article for earlier-than-normal posting.
Wow… For a week of unparalleled volatility, the Dow declined 1.2% (up 4.9% y-t-d) and the S&P500 dipped 0.5% (up 1.9%). The Utilities fell 1.1% (up 4.8%), and the Morgan Stanley Consumer index slipped 0.9% (up 1.7%). Economically-sensitive issues were under pressure. The Transports dropped 3.9% (up 4.6%), and the Morgan Stanley Cyclical index fell 2.0% (up 1.7%). The small cap Russell 2000 ended the week down only 0.3% (down 0.2%), while the S&P400 Mid-Cap index declined 1.5% (up 4.2%). The NASDAQ100 fell 1.9% (up 7.5%), and the Morgan Stanley High Tech index declined 1.6% (up 7.5%). The Semiconductors sank 3.3% (up 4.3%). The Street.com Internet Index declined 1.1% (up 7.9%), and the NASDAQ Telecommunications index dropped 2.3% (up 9.8%). The Biotechs slipped 0.2% (up 0.7%). Financial stocks seemed to catch a bid at the end of the week… From yesterday’s lows to today’s highs, the Broker/Dealers rallied 15.7% and the Banks rallied 10.9%. For the week, the Broker/Dealers gained 0.7% (down 8.2%) and the Banks surged 4.0% (down 6.3%). With bullion declining $15.40, the HUI gold index sank 11.5% (down 9.5%).
Three-month T-bill rates this week collapsed 86 bps to 3.75%. Two-year U.S. government yields sank 29 bps to 4.17%. Five-year yields fell 26 bps to 4.34%. Ten-year Treasury yields dropped 14 bps to 4.67%. Long-bond yields ended the week down 6 bps to 4.98%. The 2yr/10yr spread ended the week at a notable 50 bps. The implied yield on 3-month December ’07 Eurodollars sank 20 bps to 4.715%. Benchmark Fannie Mae MBS yields declined 8 bps to 6.10%, as the spread to 10-yr Treasuries surged to 143 bps – this week moving to the widest levels since 2002. The spread on Fannie’s 5% 2017 note widened 5 to 67, and the spread on Freddie’s 5% 2017 note widened 5 to 66. The 10-year dollar swap spread increased almost 4 to 75.6. Corporate bond spreads widened wildly, with the spread on a junk index ending the week 15 bps wider.
Credit Market Dislocation Watch:
August 17 – Los Angeles Times (E. Scott Reckard and Annette Haddad): “Anxious customers jammed the phone lines and website of Countrywide Bank and crowded its branch offices to pull out their savings because of concerns about the financial problems of the mortgage lender that owns the bank… The rush to withdraw money - by depositors that included a former Los Angeles Kings star hockey player and an executive of a rival home-loan company - came a day after fears arose that Countrywide Financial could file for bankruptcy protection because of a worsening credit crunch stemming from the sub-prime mortgage meltdown.”
August 17 – Bloomberg (Mark Pittman): “Asset-backed commercial paper yields soared by the most since the Sept. 11, 2001, terrorist attacks after the Federal Reserve cut its discount rate to try to calm financial markets. Top-rated asset-backed commercial paper maturing Aug. 20 yielded 5.99%, up 39 bps since yesterday and the most since a 45 bps increase on Sept. 20 in the wake of the terrorist attacks in New York City and Washington.”
August 14 - Financial Times (Gillian Tett, Paul J. Davies and Norma Cohen): “Policymakers and investors have been obsessed in recent years about the potential for a hedge fund collapse to spread financial panic. But it seems one of the biggest threats to stability is coming from the age-old risk of short-term borrowing to fund investments in illiquid long-term products. In a corner of the market few people knew existed, regulators are scrambling to understand what is happening in structured investment vehicles (SIVs), a breed of often huge, mainly bank-run, programmes designed to profit from the difference between short-term borrowing rates and longer-term returns from structured product investments. These have proliferated in recent years and control assets worth hundreds of billions of dollars. Depending on whether they are fully rated by credit rating agencies and on how strictly they have to conform to certain rules, they are known as SIVs, SIV-lites, or conduits. They are typically quite opaque, invest in complex securities and often do not need to be displayed on a bank’s balance sheet. It seems they have played a key role in last week’s liquidity crunch.”
August 16 - Financial Times (Peter Garnham ): “As the turmoil on credit markets has spread to other asset classes, currency investors have been scrambling to reduce speculative trades. The result has been a sharp unwinding of the carry trade, where funds are borrowed in currencies of countries with low interest rates to invest in higher yielding assets elsewhere. The carry trade, particularly using the low-yielding yen, has been a huge source of funding for speculative trades across asset classes. But now the yen is surging against high-yielding currencies like the Australian and New Zealand dollars as traders take bets off the table. ‘All of a sudden, the carry trade is frightening and a big sell - what a difference a few weeks make,’ says Richard Wiltshire, at IG Markets.”
August 14 – Bloomberg (Mark Pittman): “Seventeen Canadian asset-backed commercial paper issuers, including Coventree Inc., are seeking back up financing from banks after failing to sell their short-term debt, ratings company DBRS said. Some banks are yet to pony up in response to the funding requests, DBRS analysts led by managing director Huston Loke said. If the issuers can’t get funding, they may default after a grace period, DBRS said. The issuers cited ‘market disruption’ for calling on back up financing. The sellers are among those unable to find buyers for their short-term debt as subprime mortgage woes in the U.S. spread to new credit markets. Most asset-backed commercial paper issuers ‘have liquidity backed notes maturing on most business days,’ Toronto-based DBRS said. ‘The fact that some market participants declared a market disruption event on Aug. 13 may affect the ability’ of issuers to roll over their debt.”
August 15 – Bloomberg (Jody Shenn): “Difficulties in finding new buyers for some types of maturing commercial paper may lead companies to ‘dump’ $50 billion to $75 billion of assets on the market, and shift the financing or ownership of as much as $125 billion of debt to banks and other entities, according to UBS AG.”
August 17 – Bloomberg (Daniel Kruger): “The spreading subprime contagion has sparked a credit crisis on par with the collapse of hedge fund Long-Term Capital Management LP in 1998, short-term borrowing rates show. Three-month Treasury bill yields have fallen to 1.75 percentage points less than the London interbank offered rate, after reaching 1.66 percentage points yesterday. The last time the ‘TED’ spread, as it is known, was that wide was October 1998, after Russia defaulted on $40 billion of debt and Greenwich, Connecticut-based LTCM lost $4 billion from bad bets on interest rates.”
August 13 – Financial Times (Anuj Gangahar in New York and Kate Burgess): “The much-heralded financial rocket scientists responsible for the explosion in complex mathematical trading strategies are bracing themselves for fresh pain after what one team of analysts called ‘the perfect storm’ last week. Quantitative strategists, or ‘quants’ as they are known, attempt to profit from pricing inefficiencies identified through mathematical models. These send buy and sell signals on small variations in price between different securities. One hedge funds manager said the average quantitative fund manager was down about 15 per cent in the first few days of August. ‘Nothing seems to be working. Previously uncorrelated factors have recently been falling with the same pace, leaving investors with very few places to hide,’ said Citigroup analysts… Statistical arbitrage funds have run into particular problems. Their mathematical models rely on past trading patterns to predict how particular securities will perform in the future if other securities, say, fall in price. But their models are unlikely to take into account current trading conditions where investors, desperate to raise cash, are selling everything they can. They are also unwinding short positions, which means buying back stock they sold earlier. Thus, companies with poor prospects have seen shares rise and vice versa, undermining the logic of ‘stat arb’ models. Compounding the problem is that many stat arb managers have borrowed heavily to buy shares.”
August 14 - Financial Times (James Mackintosh): “Goldman Sachs is to inject $2bn of its own money to bail out its Global Equity Opportunities hedge fund in an embarrassing admission that its highly regarded computerised funds malfunctioned last week. The investment bank has raised a further $1bn from outside investors to support the $3.6bn GEO fund, which lost about $1.5bn when computer models failed to predict market turbulence. The new investors include Hank Greenberg, former chairman of American International Group, hedge fund Perry Capital and Eli Broad, the US billionaire. Goldman, the second-largest hedge fund manager, said its computer-driven, or quantitative, funds had been hit by unpredictable price movements…”
August 17 – Dow Jones: “In recent weeks the rates on junk bonds have soared to more than 500 basis points over treasury bonds, from 250 basis points at the beginning of summer. The market for many derivative products based on subprime mortgages has dried up entirely.”
August 17 – Bloomberg (Jeremy R. Cooke): “Investors pulled money out of U.S. high-yield municipal bond mutual funds at the fastest weekly rate in more than 12 years… (from AMG)… The funds reported net outflows of $234 million during the Week…”
Investment grade debt issuers included Wal-Mart 2.75bn, Johnson & Johnson $2.2bn, Gulf South Pipeline $500 million, Appalachian $500 million, and Safeway $500 million.
No junk issuance again this week.
Convert issuers included Verisign $1.1bn.
No international dollar bond issuance this week included million.
August 17 – Bloomberg (Caroline Salas): “The percentage of so-called distressed bonds in the U.S. high-yield, high-risk market had its biggest monthly increase since February 2003 as risk premiums rose, according to Merrill Lynch & Co. The distress ratio climbed 2.5 percentage points to 3.8% as of Aug. 15, its highest level since March 2006…”
August 16 – Bloomberg (Lester Pimentel): “Emerging-market bonds tumbled, pushing the risk premium investors demand to hold developing nation debt to the highest in more 21 months as global stocks plunged. The spread, or extra yield, on emerging-market bonds over U.S. Treasuries widened 27 bps…to 2.49 percentage points…”
German 10-year bund yields fell 7 bps to 4.29%, while a volatile DAX equities index recovered 0.5% (up 11.8% y-t-d). Japanese 10-year “JGB” yields dropped 14 bps to 1.575%. The Nikkei 225 sank 8.9% (down 11.3% y-t-d). Emerging debt, equity and currencies markets took it on the chin. Brazil’s benchmark dollar bond yields increased 5 bps this week to 6.30%. Brazil’s Bovespa equities index sank 7.8% (up 9.1% y-t-d). The Mexican Bolsa fell 3.1% (up 1.1% y-t-d). Mexico’s 10-year $ yields rose 9 bps to 5.92%. Russia’s RTS equities index fell 1.9% (down 3.2% y-t-d). India’s Sensex equities index dropped 6.3% (up 2.6% y-t-d). China’s Shanghai Composite index ended the week down only 2.0% (up 74% y-t-d and 190% over the past year).
Freddie Mac posted 30-year fixed mortgage rates rose 3 bps this past week to 6.62%. Fifteen-year fixed rates increased 5 bps to 6.30% (up bps y-o-y). One-year adjustable rates added 2 bps to 5.67%. The Mortgage Bankers Association applications data is being significantly distorted by borrowers submitting multiple applications. I’ll disregard this data for now.
M2 (narrow) “money” dipped $1.9bn to $7.282 TN (week of 8/6). Narrow “money” has expanded $239bn y-t-d, or 5.5% annualized, and $447bn, or 6.5%, over the past year. For the week, Currency decreased $0.6bn, while Demand & Checkable Deposits increased $4.2bn. Savings Deposits fell $10.8bn, while Small Denominated Deposits added $1.4bn. Retail Money Fund assets rose $4.0bn.
Total Money Market Fund Assets (from Invest. Co Inst) surged $43.8bn last week (4-wk gain of $128bn) to a record $2.701 TN. Money Fund Assets have increased $319bn y-t-d, a 21.1% rate, and $505bn over 52 weeks, or 23%.
Total Commercial Paper sank $91bn last week to $2.132 TN, now with a y-t-d gain of of only $158bn (12.6% annualized). CP has increased $327bn, or 18.1%, over the past 52 weeks.
Fed Foreign Holdings of Treasury, Agency Debt last week (ended 8/15) declined $1.6bn to $2.005 TN. “Custody holdings” were up $253bn y-t-d (22.7% annualized) and $338bn during the past year, or 20.3%. Federal Reserve Credit last week jumped $17.2bn to $867.8bn. Fed Credit has now increased $15.6bn y-t-d (2.9% annualized), with one-year growth of $38.5bn (4.6%).
International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $883bn y-t-d (29% annualized) and $1.10 TN y-o-y (24%) to a record $5.694 TN.
The spot dollar index jumped 0.9% this week to 81.43. The “yen carry trade” came under intense stress. The Japanese currency surged 3.7% against the dollar, while gaining 10% against the New Zealand dollar, 8.9% against the Australia dollar, 7.1% against the Brazilian real and 6.0% compared to the South African rand. The Swiss franc declined 0.6% versus the dollar and the Euro fell 1.5%.
For the week, Gold dropped 2.3% to $657.20, while Silver sank 8.3% to $11.80. Copper dropped 6.3%. September crude managed to gain 51 cents to $71.98. September gasoline jumped 4.3%, and September Natural Gas gained 2.8% (2-wk gain of 15%). For the week, the CRB index fell 1.5% (down 0.3% y-t-d) and the Goldman Sachs Commodities Index (GSCI) 1.6% (up 11.1% y-t-d).
August 13 – Bloomberg (Kathleen Chu and Katsuyo Kuwako): “Condominium prices in Tokyo and neighboring prefectures rose 13% in July to the highest level since November 1992, as supply declined for a seventh-straight month… The average price per unit for the region gained to 53 million yen ($449,724) from a year earlier…”
August 13 – Bloomberg (Nipa Piboontanasawat): “Inflation in China…accelerated to the highest rate in more than 10 years, fueling speculation that the government may raise borrowing costs for a fourth time in 2007. Consumer prices jumped 5.6% in July from a year earlier, after gaining 4.4% in June… Food costs climbed 15.4% after a shortage of pigs pushed up meat prices and bad weather destroyed crops.”
August 13 – Bloomberg (Nipa Piboontanasawat): “China’s retail sales grew at the fastest pace in more than three years, buoyed by a stock market rally and higher wages and prices. Spending climbed 16.4% to 699.8 billion yuan ($92 billion) in July from a year earlier…”
August 15 – Bloomberg (Nipa Piboontanasawat): “China’s industrial production rose 18% in July, slowing for the first time in three months after cuts to export incentives. Output grew less than June's 19.4%...”
August 16 - Financial Times (Jamil Anderlini): “Listed Chinese companies are lining up in their hundreds to sell corporate bonds and pay off bank loans after the securities regulator issued formal rules governing the nascent sector… A quota system that kept annual corporate bond issuance below Rmb100bn ($13.2bn) last year has been abolished and listed companies are now permitted to repay bank debt with bond proceeds for the first time. Companies with high levels of debt, particularly in the power, property and transport infrastructure industries are expected to be the first to sell bonds under the new regime…”
August 13 – Bloomberg (James Kraus): “Hong Kong’s intense system for public examinations that determine college entry has turned local tutors into highly paid celebrities who use aggressive marketing to advertise their services, the Wall Street Journal reported. A popular tutor, however, typically might instruct as many as 100 students in a single lesson, each of whom pays as much as $12.50 for the session, yielding an income for a 40-hour week of as much as $50,000…”
Asia Boom Watch:
August 15 – Bloomberg (Wahyudi Soeriaatmadja and Arijit Ghosh): “Indonesia’s economy grew the fastest in more than two years in the second quarter as exports rose and lower interest rates fueled spending and investment. Southeast Asia’s largest economy expanded 6.3% in the three months ended June 30…”
Unbalanced Global Economy Watch:
August 13 – Bloomberg (Jonas Bergman): “Swedish apartment prices rose an annual 23% in the three-month period through July, up from a 15% increase in the month-earlier period, as unemployment dropped and tax cuts spurred wealth growth.”
August 15 – Bloomberg (Maria Levitov): “Russian foreign direct investment more than doubled to $15.8 billion in the first half of the year.”
August 14 – Bloomberg (Tracy Withers): “New Zealand’s retail sales unexpectedly fell in June as record-high interest rates curbed consumer spending. The nation’s currency slumped to a 10-week low.”
Bursting Bubble Economy Watch:
August 15 – Bloomberg (Shobhana Chandra): “Confidence among U.S. homebuilders fell more than forecast in August to the lowest since 1991, as cancellations and more restrictions on lending took a toll. The National Association of Home Builders index of builder confidence declined to 22, from 24 in July… A reading below 50 means most respondents view conditions as poor. The gauge has decreased for six consecutive months.”
August 16 - Financial Times (Matthew Garrahan and James Politi): “The credit crunch shaking world markets has hit Hollywood after Goldman Sachs and Deutsche Bank, which were trying to raise up to $1bn to finance films for Metro-Goldwyn-Mayer, withdrew their commitment to underwrite the deal. Bringing in private equity, hedge fund and institutional investors to fund ‘slates’ of several films has become a popular way for Hollywood studios to spread the risk attached to production. But with credit markets tightening, the attempt by the banks to raise $700m-$1bn for MGM productions and co-productions has been blown off-course…”
Central Banker Watch:
August 17 – Bloomberg (Vivien Lou Chen): “Federal Reserve Bank of New York President Timothy Geithner and Fed Vice Chairman Donald Kohn told a group of banks including JPMorgan Chase & Co., Citigroup Inc. and Goldman Sachs Group Inc. that the central bank is encouraging use of its window for direct loans. Geithner requested a conference call today of the Clearing House, a group of major commercial and investment banks, the…group said in a statement. Kohn participated in the call, the statement said… ‘Both encouraged use of the discount window and recognized such use as a sign of strength,’ the group said… The bank representatives on the call ‘reacted very positively’ to the comments…”
Financial Sphere Bubble Watch:
August 16 - Financial Times (David Oakley and Anuj Gangahar ): “Equity derivatives volumes are surging to daily records as traders scramble to take advantage of or hedge themselves against market turmoil and the resulting spike in volatility. In the US, average daily volumes on CME group, the world’s largest derivatives exchange, stands at 16.6m contracts this month so far, a 99% increase over the combined month of August last year. The Options Clearing Corporation, which collates the volumes on all the US options exchanges, said that a new daily record was set on July 26 when 21.3m contracts were cleared.”
August 14 - Financial Times (Stacy-Marie Ishmael): “The back offices of investment banks are struggling to cope with the recent surge in trading volumes in credit derivatives as investors sought protection designed to hedge against risk. As voltatility rattled global credit markets throughout August, staff at investment banks across Europe and the US have been scrambling to keep on top of the requisite paper work, which is piling up in back offices. ‘Volumes have exploded and we’re struggling to keep up,’ said a person at a US bank. Hedge funds said the delays in documentation and settlement are leading to unexecuted trades, difficulty in valuing assets in a timely manner and additional risk.In New York, daily trading volumes for an index comprising credit default swaps on 125 investment grade North American companies reached some $221bn last week, while similar products in Europe attracted notional volumes of €200bn ($272bn)…”
August 14 - Financial Times (Jennifer Hughes): “Auditors are preparing for particularly careful scrutiny of companies’ assumptions about valuation and the risks posed to their businesses in the light of current market volatility. Two of the Big Four UK accountancy groups have issued internal memos advising their audit teams on the issues that the current market storm could throw up. Concerns range from appropriately valuing illiquid and complex financial instruments to the much larger, though as yet apparently remote, danger that the potential balance sheet impact of recent events poses a material risk to a company’s survival… ‘Auditors would be careful anyway but now we will think more deeply about the possibility of contagion effects. This means what may have been a straightforward assumption last year may be more problematic this time,’ said Martyn Jones, national audit technical partner at Deloitte.”
August 17, 2007 – Reuters (Patrick Rucker): “Fannie Mae, the nation’s largest source of home loan funding, increased its holdings of risky subprime loans in 2006 while its profits fell that year… As the U.S. volume of higher-risk subprime loans increased from 2003 through mid-2006, Fannie Mae said its ‘purchase and securitization of loans that pose a higher credit risk ... also increased…’ Net income at the company fell 36% to $4.06 billion last year from $6.35 billion in 2005, the company said in its 2006 annual report filing with the Securities and Exchange Commission.”
Mortgage Finance Bust Watch:
August 15 – The Wall Street Journal (Aaron Lucchetti and Serena Ng): “In 2000, Standard & Poor’s made a decision about an arcane corner of the mortgage market. It said a type of mortgage that involves a ‘piggyback,’ where borrowers simultaneously take out a second loan for the down payment, was no more likely to default than a standard mortgage. While its pronouncement went unnoticed outside the mortgage world, piggybacks soon were part of a movement that transformed America’s home-loan industry: a boom in ‘subprime’ mortgages taken out by buyers with weak credit. Six years later, S&P reversed its view of loans with piggybacks. It said they actually were far more likely to default. By then, however, they and other newfangled loans were key parts of a massive $1.1 trillion subprime-mortgage market. Today that market is a mess. As defaults have increased, investors who bought bonds and other securities based on the mortgages have found their securities losing value, or in some cases difficult to value at all. Some hedge funds that feasted on the securities imploded, and investors as far away as Germany and Australia have suffered.”
August 13 – DataQuick: “Southern California home sales remained at their lowest level since the mid 1990s last month as potential buyers continued to hold out for lower prices. The median price paid for a home inched back up to a peak first reached in March, tugged up by sales in high-end markets, a real estate information service reported. A total of 17,867 new and resale homes sold in Los Angeles, Riverside, San Diego, Ventura, San Bernardino and Orange counties last month. That was down 11.4% from 20,166 for the previous month, and down 27.4% from 24,614 for July last year… Last month’s sales were the slowest for any July since 1995… The strongest July was in 2003, when 38,996 homes sold.”
MBS/ABS/CDO/CP/Money Funds and Derivatives Watch:
August 14 - Financial Times (John Dizard): “As you may have heard, the 142-foot yacht Positive Carry, owned by the subprime ABS investor John Devaney, is up for sale. Not voluntarily. For this phase of the markets, the right vessel to cruise the waters off Palm Beach and Cap d’Antibes would be the private submarine Unwind, armed with the torpedoes Delta Hedge and Gamma Hedge. It has been an educational summer for all in the credit markets… Market people can sift through the after-action reports to see what hit them, and bury their dead positions before the next round of conflict between models and reality. As is customary, the risk managers were well-prepared for the previous war. For 20 years numerate investors have been complaining about measurements of portfolio risk that use the Gaussian distribution, or bell curve. Every four or five years, they are told, their portfolios suffer from a once-in-50-years event. Something is off here.”
August 16 - Financial Times: “To roll - with the punches - or not? This is the big question hanging over a corner of the vast asset-backed commercial paper (ABCP) market, worth roughly $1,000bn. This market, which provides short-term funding for an array of issuers, including mortgage companies, has shown unmistakable signs of stress recently, with spreads widening dramatically in August. But the real crunch will come if buyers decide not to roll over their exposure. Increasingly, ABCP issued by mortgage originators, using mortgage assets as collateral, is extendible. This means the maturity can be pushed back several months if the market freezes up… Issuers have a few other lifelines. The most important one is the access to back-up lines of credit, on an unsecured basis, offered by the banks. But these come with a couple of caveats. Some might have clauses in them that mean they cannot be automatically drawn down, even when markets are in turmoil. Most importantly, use of such a facility is a sign of such duress it is unlikey to be repeated.”
August 16 - Financial Times (Paul J Davies ): “Ratings agencies look set to issue a wave of downgrades on complex structured bonds that are backed by pools of other asset-backed bonds, loans and other debt. Downgrades to these instruments, known as collateralised debt obligations (CDOs), could spark a bout of forced sales and increase the pain being felt by hedge funds and others who have bought the securities, including bank-run conduits and structured investment vehicles (SIVs). Dresdner Kleinwort analysts said 101 different CDOs are under the agencies’ spotlight… Most of the deals are CDOs of mezzanine ABS. These buy up pools of the junior ranking tranches of asset-backed securities (ABS) that are usually rated in the region of BBB and include residential mortgage-backed securities, commercial mortgage-backed securities and other kinds of CDOs. Many of these deals were buyers of US subprime mortgage-backed bonds.”
August 15 - Financial Times (Richard Beales and Saskia Scholtes): “When news emerged this summer that two funds run by Bear Stearns had suffered large losses, some investors expressed fury with the funds – and Bear. But behind the scenes, some officials in the banking world are pointing the finger at another target – the institutions which issued the high credit ratings on the complex, but supposedly safe, securities that the funds invested in. ‘This stuff wasn’t triple-A. There’s going to be a big debate about this,’ said a person close to Jimmy Cayne, chief executive of Bear. The comment points to a much wider debate that is emerging on Wall Street and in the City of London – and is even spreading to the European Commission… One argument contends that in their eagerness for fees the agencies helped investment banks come up with clever, complicated structures that achieved high ratings, even though they realised that new-fangled instruments with an AAA rating would most likely behave differently from traditional bonds with the same high rating.”
August 16 - Financial Times (Tobias Buck): “The European Commission is to investigate credit ratings agencies amid growing dismay over their slow response to the subprime mortgage crisis. Officials in Brussels and many other critics, believe the ratings agencies failed to act quickly enough to warn investors about the risks of investing in securities backed by US subprime mortgages - the sector whose troubles triggered the recent global market volatility. In the US, Barney Frank, Democrat chairman of the House financial services committee, said he planned to hold hearings on the agencies’ performance next month. He said the agencies had "not done a good job" in the current crisis.”
August 15 – Bloomberg (Patricia Kuo): “The U.S. subprime mortgage crisis will cost credit investors about $150 billion in losses worldwide, according to Calyon, the investment banking unit of Credit Agricole SA, France’s third-largest bank… Foreclosures may reach 20% of the $1.3 trillion of subprime mortgages outstanding, according to a research note…”
Real Estate Bubbles Watch:
August 13 – Bloomberg (Hui-yong Yu and Michael B. Marois): “The California Public Employees’ Retirement System, the $245 billion pension fund that’s the largest in the U.S., may increase its real estate holdings to $36 billion over five years following its first major review of property assets in 11 years. Putting half of its real estate investments outside the U.S. is one recommendation the Sacramento-based pension fund's staff is presenting to the board of Calpers…”
M&A and Private-Equity Bubble Watch:
August 15 - Financial Times (James Politi, James Mackintosh, Peter Thal, Larsen and David Oakley): “A unit of Kohlberg Kravis Roberts, the powerful US private equity group, became the latest victim of the subprime mortgage crisis yesterday, casting a cloud over its plans to raise $1.25bn by listing. KKR Financial - floated two years ago to raise money from stock market investors for ‘mezzanine’ debt deals - said it was forced to sell $5.1bn in residential mortgages for a loss of $40m. The San Francisco-based unit also warned it could lose up to $250m due to its remaining portfolio of residential mortgage-backed securities, worth $5.8bn. KKR Financial said this was caused by its inability to fund the mortgage loans by issuing asset-backed commercial paper.”
August 14 - Financial Times (Jeremy Grant): “The US government is on a ‘burning platform’ of unsustainable policies and practices with fiscal deficits, chronic healthcare underfunding, immigration and overseas military commitments threatening a crisis if action is not taken soon, the country’s top government inspector has warned. David Walker, comptroller general of the US, issued the unusually downbeat assessment of his country’s future in a report that lays out what he called ‘chilling long-term simulations’.These include ‘dramatic’ tax rises, slashed government services and the large-scale dumping by foreign governments of holdings of US debt. Drawing parallels with the end of the Roman empire, Mr Walker warned there were ‘striking similarities’ between America’s current situation and the factors that brought down Rome, including ‘declining moral values and political civility at home, an over-confident and over-extended military in foreign lands and fiscal irresponsibility by the central government’… Mr Walker’s views carry weight because he is a non-partisan figure in charge of the Government Accountability Office, often described as the investigative arm of the US Congress.”
August 15 - Financial Times (Peter Smith and James Mackintosh): “Basis Capital is considering legal action against banks that pulled credit lines to it, a move the Australian fund manager said could have contributed to falls of more than 80% in the value of one of its hedge funds. Basis told investors in a letter… it had ‘referred matters to its legal and financial advisers in order to explore all possible avenues’, although it did not name targets. Its lenders included many of the biggest Wall Street banks. Basis managed close to $1bn before its Yield Alpha fund was hammered by the collapse in structured bonds linked to the US subprime crisis.”
August 14 – The Wall Street Journal (Jesse Drucker): “U.S. lawmakers are examining yet another tax perk enjoyed by hedge funds: Many of these funds lend money like banks, but unlike traditional lenders, often don’t pay U.S. taxes on the profits. Hedge funds, which control liquid pools of capital with little regulatory oversight, are a growing presence in the lending business. They increasingly take part in lending syndicates with traditional banks, often indirectly, and also make direct loans, frequently to riskier or smaller companies that may have difficulty obtaining traditional financing. Indeed, the additional liquidity provided by hedge funds has helped contribute to the boom of easy credit that is now coming to a halt.”
Fed to the Rescue:
Aug. 15 – Bloomberg (Anthony Massucci and Kathleen Hays): “William Poole, president of the St. Louis Federal Reserve Bank, said the subprime mortgage rout doesn’t threaten U.S. economic growth, and only a ‘calamity’ would justify an interest-rate cut now… ‘It’s premature to say this upset in the market is changing the course of the economy in any fundamental way,’ Poole, 70, said in the interview… ‘If the Federal Reserve were to act when it turns out there is no impact, then clearly the market would say these guys really don’t have the intelligence they need to have a policy actually based on solid evidence.’” August 17 – Financial Times (Eoin Callan): “The Federal Reserve took emergency steps to limit the damage to the US economy from the crisis in global credit markets on Friday by cutting the discount rate at which it makes loans to banks. The central bank cut the rate by half a percentage point to 5.75%, while keeping the main federal funds rate on hold at 5.25%. The surprise move, which was agreed during an emergency conference call on Thursday night, makes it more likely the Fed will cut its main rate next month and may help ease liquidity in financial markets and limit the blow to financial institutions from the deterioration in assets exposed to the meltdown in the US subprime mortgage sector.”
I was as mystified as anyone with Dr. Poole’s Wednesday evening comments. U.S. and global Credit systems were succumbing to extraordinary stress, with overt negative ramifications for economic activity – especially for the U.S. Bubble Economy. Poole, “who confers regularly with regional business contacts,” must not have many friends on Wall Street. The Board of Governors in Washington, the Federal Reserve Bank of New York, the Treasury and Administration do.
Today’s 50 bps reduction in the discount rate vaunted Dr. Bernanke, as a CNBC commentator put it, “to rock star status.” Others referred ecstatically to “the new maestro.” Whether it was merely coincidence that the surprise cut came one hour before trading opened for a key option-expiration session in U.S. equity markets (many index options settling based on opening prices), we can only speculate. But the relieved bulls took today’s move as a signal that the Bernanke Fed would maintain a “sophisticated” approach to market support operations. For an increasingly desperate Wall Street, it was pure genius.
It is Wall Street’s hope that Fed rate cuts will, once again, work their magic to restore confidence and incite a renewed appetite for risk. I have little doubt that Fed comments and cuts will have dramatic and immediate effects on a terribly distorted stock market, along with highly unstable financial markets generally. Yet this week’s wild gyrations will do little to remedy the faltering “quant” funds. And this week’s currency and emerging market tumult created only further stress in the leveraged speculating community and derivatives marketplace.
Bear market rallies are notoriously the most ferocious. And with the massive shorting that features prominently in today’s marketplace - most related to the problematic proliferation of various hedging programs and leveraged “market neutral” strategies - the Fed maintains extraordinary power to incite stock market panic buying - on demand.
The more paramount issue is whether the Fed and global central bankers have the capacity to maintain the necessary Credit creation to sustain inflated asset markets and Bubble Economies over the intermediate term. More specifically and immediately, will Fed rate cuts halt a rapidly unfolding mortgage Credit collapse? I actually believe the acute crisis unfolding throughout the commercial paper market can likely be ameliorated through aggressive lending at the Fed’s discount window. But the tattered MBS marketplace is a whole different story.
With a liquidity crisis forcing even national lending powerhouse Countrywide to dramatically tighten lending standards, the dearth of Credit Availability for subprime, Alt-A, and jumbo mortgage finance – virtually everything outside of GSE-related “conventional” mortgages - has reached crisis proportions. Today, holders of MBS – especially the “private-label” varieties – face a confluence of extraordinary uncertainty regarding MBS illiquidity, the further direction of interest rates, general economic prospects, and prospective Credit losses – along with systemic liquidity uncertainties. There will be evolving fears of a California bust and the viability of the mortgage insurance industry. It will be long before the marketplace recognizes the devastating ramifications of the jumbo mortgage freeze – especially for home prices throughout California and elsewhere across the country.
Commenting on Amgen’s announcement of layoffs (2,600) and capital spending cutbacks, a CNBC reporter highlighted the heightened risk to local (Woodland Hills, CA) real estate prices from major layoffs announced by two of the areas largest employers (Amgen and Countrywide). The average Amgen employee is said to make $160,000, with many scientists and skilled workers now having little alternative but to relocate for gainful employment. Throughout Southern California, thousands of previously well compensated mortgage brokers, real estate agents, related service providers, automobile salesmen, etc. will be forced to change their lifestyles.
Late-cycle Credit Bubble excesses were having a major – yet unappreciated – stimulating impact on upper-end incomes. From California real estate to Wall Street securities markets, unprecedented Credit-induced asset inflation has been feeding both directly and indirectly into the paychecks of a wide-ranging number of industries and (“service”) sectors – from biotech, to alternative energy, to Hollywood, to professional sports and the media/advertising, and to finance. With the bursting of the Credit Bubble and the accompanied dramatic downturn in Credit Availability and Marketplace Liquidity, expect a snowball-like surge in the number of layoffs of highly-compensated employees and spending cutbacks (marketing and capital investment).
It is also my view that the Bubble-related boom at the “upper end” has played an instrumental role in the U.S. economy’s vaunted “resiliency.” This is actually a typical Bubble Economy attribute, one that creates unrecognized susceptibility to what eventually becomes an abrupt and radical change in monetary conditions (the bursting of the Credit Bubble). Mr. Poole’s contacts in business may report that everything appears just fine today, but apparently little do they appreciate that Financial Sphere Tumult is in the Process of Pulling the Rug Out from Beneath the Economic Sphere.
The New York Times’ Floyd Norris, in an article that ran last weekend titled Modern Finance Suffers its Version of a Run on the Bank, quoted Pimco’s Bill Gross. “Our current system of levered finance and its related structures may be critically flawed. Nothing within it allows for the hedging of liquidity risk, and that is the problem at the moment."
It would be natural for the proponents of contemporary finance to take comfort this weekend in the notion that the Fed is both able and willing to rectify this “critical flaw.” But I don’t believe “hedging for liquidity risk” is the real issue. Rather, the fundamental problem with Wall Street finance is that the proliferation of speculating, leveraging and hedging strategies ensures an eventual liquidity crisis. As well as derivatives function for individual firms seeking to shift or hedge risk, they are a smoldering disaster when an entire marketplace perceives it can lay off market risk. There will simply be no one take the other side of the trade.
Similar dynamics are in play for Credit “insurance.” Credit derivatives and “arbitrage” appear to work too well during the boom, ensuring Credit excesses and wholesale risk distortions that expand over the life of the boom. However, this “market” will inevitably prove unviable during the downside of the Credit cycle. Again, there will be unmanageable losses – in this case mushrooming Credit losses - and few with the wherewithal to make good on their obligations.
Contemporary Wall Street finance is terribly flawed because of its ability to avoid adjustments and corrections – for its capacity – its dogmatism – its determination to finance history’s most spectacular Credit and economic Bubbles. The Fed may succeed in slowing at least temporarily the unwind process. I do not, however, believe central bankers can resuscitate the bursting U.S. Credit Bubble. Confidence has been broken and some of the incredible nonsense of it all has been revealed. This, unlike 1998, is not simply a case of reversing the de-leveraging process and inciting animal spirits. It is also not 2000-2002, when the Credit system (and leveraged speculating community) maintained a strong expansionary bias (emerging Mortgage Finance, hedge fund, broker/dealer and Credit derivatives Bubbles) that would reflate the tech sector and the mildly recessionary U.S. economy.
Reiterating previously expounded views, the dilemma today is that it requires enormous Credit growth and risk intermediation to sustain what has become a global proliferation of myriad Bubbles. The task involves sustaining inflated financial asset prices, real asset prices, incomes, corporate profits and government receipts – not just next week but going forward. The amount of required ongoing Credit creation is unprecedented, at the same time that bursting speculative Bubbles spur unparalleled deleveraging (forced selling of previously leveraged securities holdings). GSE balance sheets aren’t available to absorb any deleveraging, placing the entire role on global central bankers. Central banks have great capacity to create liquidity. But their ability to manage the unfolding breakdown in private-sector risk intermediation is much more ambiguous.