Three-month Treasury bill rates declined 4 bps this past week to 2.19%. Two-year government yields jumped 15 bps to 2.06%. Five-year T-note yields rose 10 bps to 2.86%, and ten-year yields increased 4 bps to 3.81%. Long-bond yields were little changed at 4.58%. The 2yr/10yr spread ended the week at 175 bps. The implied yield on 3-month December ’08 Eurodollars jumped 23 bps to 2.615%. Benchmark Fannie MBS yields surged a notable 22 bps to 5.73%, again this week dramatically under-performing Treasuries. This put the two-week rise in benchmark MBS yields at a stunning 54 bps, with spreads versus Treasuries widening to the widest level in eight years (192bps). The spread on Fannie’s 5% 2017 note was about one wider at 72 bps and the spread of Freddie’s 5% 2017 note one wider at 71. The 10-year dollar swap spread increased 6.25 to 72.75, the widest since year-end. Corporate bond spreads were wider, especially in the (dislocated) investment-grade sector. An index of junk bonds spreads declined 17 bps.
There was little debt issuance this week. Convert issuance included NASDAQ Stock Market $425 million and Silver Standard $120 million.
German 10-year bund yields rose 5 bps to 4.0%, while the DAX equities index slipped 0.4% (down 15.6% y-t-d). Japanese “JGB” yields were unchanged at 1.45%. The Nikkei 225 declined 0.9% (down 11.8% y-t-d and 25.4% y-o-y). Emerging debt and equities markets were, again, quite volatile. Brazil’s benchmark dollar bond yields dropped 17 bps to 5.78%. Brazil’s Bovespa equities index surged 5.4% (up 1.1% y-t-d). The Mexican Bolsa rallied 2.7% (unchanged y-t-d). Mexico’s 10-year $ yields added 2 bps to 5.28%. Russia’s RTS equities index rallied 4.5% (down 9.2% y-t-d). India’s Sensex equities index sank 4.2%, extending y-t-d declines to 14.5%. China’s Shanghai Exchange fell 2.8% this week (down 16.9% y-t-d).
Freddie Mac posted 30-year fixed mortgage rates surged 32 bps this week to 6.04%. Mortgage rates were up 56 bps in four weeks, with borrowing costs now down only 18 bps from the year ago level. Fifteen-year fixed rates jumped an extraordinary 39 bps to 5.64% (down 33bps y-o-y). One-year adjustable rates dipped 2 bps to 4.98% (down 51bps y-o-y).
Bank Credit declined $22.3bn during the most recent data week (2/13) to $9.315 TN. Bank Credit has posted a 30-week surge of $671bn (13.5% annualized) and a 52-week rise of $943bn, or 11.3%. For the week, Securities Credit rose $9.6bn. Loans & Leases dropped $31.9bn to $6.851 TN (30-wk gain of $527bn). C&I loans added $0.3bn, with one-year growth of 21.1%. Real Estate loans fell $9.6bn (up 7.0% y-o-y). Consumer loans increased $2.0bn. Securities loans dropped $14.3bn, and Other loans declined $10.4bn. Examining the liability side, Deposits declined $20.4bn.
M2 (narrow) “money” supply rose $16.3bn to a record $7.586 TN (week of 2/11). Narrow “money” expanded $123bn over the past six weeks, with a y-o-y rise of $484bn, or 6.8%. For the week, Currency added $0.8bn, while Demand & Checkable Deposits dropped $25.1bn. Savings Deposits jumped $33.4bn, while Small Denominated Deposits dipped $2.1bn. Retail Money Fund assets increased $9.4bn.
Total Money Market Fund assets (from Invest Co Inst) rose another $20bn last week (7-wk gain $295bn) to a record $3.408 TN. Money Fund assets have posted a 30-week rise of $824bn (55% annualized) and a one-year increase of $988bn (41%).
Asset-Backed Securities (ABS) issuance slowed to $2.2bn. Year-to-date total US ABS issuance of $31bn (tallied by JPMorgan) is running only 30% of the level from comparable 2007. Home Equity ABS issuance of $197 million compares to $53bn in early 2007. Year-to-date CDO issuance of $1.8bn compares to the year ago $40bn.
Total Commercial Paper sank $17.8bn to $1.817 TN. CP has declined $406bn over the past 28 weeks. Asset-backed CP fell $11.7bn (28-wk drop of $411bn) to $784bn. Over the past year, total CP has contracted $198bn, or 9.8%, with ABCP down $272bn, or 25.7%.
Fed Foreign Holdings of Treasury, Agency Debt last week (ended 2/20) jumped $17.3bn to $2.130 TN. “Custody holdings” were up $73.8bn y-t-d, or 23.3% annualized, and $304bn year-over-year (16.6%). Federal Reserve Credit expanded $8.5bn last week to $867bn. Fed Credit has contracted $6.7bn y-t-d, or 5.0% annualized, while having expanded $15.2bn y-o-y (1.8%).
International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $1.347 TN y-o-y, or 27%, to a record $6.344 TN.
Global Credit Market Dislocation Watch:
February 19 – Bloomberg (Jody Shenn): “The extra yield that investors demand to own agency mortgage-backed securities over 10-year U.S. Treasuries rose to an eight-year high as record spreads on other debt hurt demand.”
February 21 – Financial Times (Sarah O’Connor, Robert Cookson and Michael Mackenzie): “Credit markets were thrown into fresh turmoil yesterday as the cost of protecting the debt of US and European companies against default surged to all-time highs. The sharp jump, which rivalled the market swing at the height of last summer’s credit shake-out, came as investors unwound highly leveraged positions in complex structured products. The move was in part prompted by fears of further unwinding as investors rushed to exit before conditions worsened. ‘There’s a domino effect taking place,’ said Mehernosh Engineer, credit strategist at BNP Paribas. ‘We are unwinding three years of excesses in the space of three days.’ The cost of insuring the debt of the 125 investment-grade companies in the benchmark iTraxx Europe rose by more than 20% to as high as 136.9 basis points… That compares with about 51bp at the start of the year.”
February 21 - The Wall Street Journal (Carrick Mollenkamp): “The global financial crisis, sparked by troubles in risky mortgage investments, is rapidly spreading into a much larger area: the market for securities tied to the credit of the world’s corporations. U.S. and European indexes that track the likelihood of corporate defaults are flashing red as traders and investors fret about the outlook for the global economy and the possibility of blowups among some $6 trillion in complex securities tied to the value of corporate bonds… While defaults among companies remain relatively low, the indexes’ moves could prove to be self-fulfilling prophecies, incurring heavy losses for investors and making it even harder for people and companies to borrow money. Adding to the anxiety: Analysts can only guess at the volume of investments tied to the indexes, who is holding them and what it would take to trigger a full-scale selloff.”
February 20 – Bloomberg (Abigail Moses and Shannon D. Harrington): “The cost of protecting corporate bonds from default soared to a record as investors purchased credit-default swaps to hedge against mounting losses in the $2 trillion market for collateralized debt obligations. ‘The market is full of rumors of unwinding of CDOs, and the price action suggests that people believe the rumors,’ said Peter Duenas-Brckovitch, head of European credit trading at Lehman… ‘It sort of has that Armageddon feel, and the market is feeding on itself.’ Constant proportion debt obligations, which package indexes of credit-default swaps, may have to unwind about $44 billion of assets, UniCredit SpA analyst Tim Brunne in Munich said… Some so-called synthetic CDOs that sold credit-default swaps on an estimated $1 trillion in debt also are at risk as investors grow concerned about plunging market values, Morgan Stanley analysts led by Sivan Mahadevan wrote… ‘The mark-to-markets on these have got to be pretty nasty,’ said Byron Douglass, an analyst at Credit Derivatives Research LLC… ‘I would imagine that as spreads go wider, more and more CDOs are probably being unwound.’”
February 19 – Financial Times (Chris Hughes): “Credit Suisse cast itself as the champion of risk management and transparency among investment banks when it unveiled record annual profits last week. But Tuesday’s revelation of a $2.85bn mark-down in its trading book has undermined the reputation for prudence that it has so assiduously tried to cultivate. Losses in the… bank’s structured credit book emerged early last week, although Brady Dougan, the chief executive, says he was unware of the situation when he presented its results on February 12. The difficulties centre on the bank’s trading inventory in residential mortgage-backed securities (RMBSs) and collateralised debt obligations (CDOs)… As the losses worsened, the bank was unaware of what was going on… The result – a $2.85bn hit on the trading book which, after adjusting for lower revenue-related bonus payments and tax, will dent first quarter net income by $1bn.”
February 20 – Financial Times (Gillian Tett): “US banks have been quietly borrowing massive amounts of money from the Federal Reserve in recent weeks by using a new measure the Fed introduced two months ago to help ease the credit crunch. The use of the Fed’s Term Auction Facility…saw borrowing of nearly $50bn of one-month funds from the Fed by mid-February. US officials say the trend shows that financial authorities have become far more adept at channelling liquidity into the banking system to alleviate financial stress… However, the move has sparked unease among some analysts about the stress developing in opaque corners of the US banking system and the banks’ growing reliance on indirect forms of government support.”
February 21 – Bloomberg (Aaron Kirchfeld and Neil Unmack): “Dresdner Bank AG, Germany’s third-largest bank, agreed to rescue its $18.8 billion K2 structured investment vehicle, joining Citigroup Inc. and HSBC Holdings Plc in putting capital at risk to bail out investment funds… Dresdner…will provide a credit line to enable K2 repay all of its senior debt… Dresdner will cut the size of the fund, which has been reduced from $31.2 billion since July, according to the statement.”
February 20 – Bloomberg (Neil Unmack): “Standard Chartered Plc abandoned a plan to refinance its $7.15 billion Whistlejacket Capital Ltd. structured investment vehicle, the largest SIV run by a bank to collapse. The London-based bank blamed the ‘continuing deterioration in the market’ for its decision… Whistlejacket will become the sixth SIV to default if it doesn’t make a payment by Feb. 21 when a three-day grace period ends…”
February 22 – Bloomberg (Christopher Condon): “Northern Trust Corp. agreed to provide capital to some of its money-market funds if they suffer losses on debt issued by Whistlejacket Capital LLC and White Pine Finance LLC. The… bank may provide as much as $229 million to eight funds managing net assets of $85.7 billion…”
February 20 – Bloomberg (Patricia Kuo and Edward Evans): “KKR Financial Holdings LLC, Kohlberg Kravis Roberts & Co.’s $18 billion publicly traded credit fund, delayed repaying some of its asset-backed commercial paper and started restructuring talks with its creditors…. About half the debt will be due by March 3 instead of Feb. 15, with the rest owed on March 25. The talks come less than six months after the fund received a $230 million cash infusion from investors after being hurt by losses on residential mortgages…”
February 21 – Bloomberg (Darrell Preston): “The collapse of the auction-rate bond market, where state and local governments go to raise cash, demonstrates that regulators are no match for Wall Street. Hundreds of auctions have failed this month, sending borrowing costs as high as 20 percent because dealers from Goldman Sachs Group Inc. to Citigroup Inc., UBS AG and Merrill Lynch & Co. stopped using their own capital to support the sales. Regulators, who allowed the manipulation of bids and lack of information to persist even after two probes in the past 15 years, are now watching a $342 billion market evaporate at the expense of taxpayers. Inadequate disclosure ‘may have masked the impact of broker-dealer bidding on rates and liquidity,’ Martha Haines, head of the Securities and Exchange Commission’s municipal office, said… ‘The large numbers of recent auction failures, which are reported to have occurred due to a reduction in bidding by broker-dealers, appears to indicate those concerns were well founded.’”
February 22 – Bloomberg (Jeremy R. Cooke): “California, Florida schools and the operator of John F. Kennedy International Airport joined a growing list of municipal borrowers exiting the U.S. auction-rate bond market as record failures push taxpayer costs higher. Thousands of auctions run by banks to set rates on the debt failed this month as investors shunned the securities and bankers refused to submit bids, sending interest costs to 10% or higher on some bonds. Auctions covering as much as $26 billion of bonds a day failed to attract enough buyers since Feb. 13…”
February 22 – Bloomberg (Jenny Strasburg): “AQR Capital Management LLC’s largest hedge fund fell almost 15% this year through Feb. 15 as market swings tripped up computer models the managers use to make trades… The assets of AQR’s Absolute Return fund dropped to $2.9 billion last month from $4 billion in the fourth quarter… Quantitative managers who rely on computers to make trades have struggled as global equity markets declined…”
February 20 – Bloomberg (Pierre Paulden, Caroline Salas and Jody Shenn): “A year ago $20 million would have gotten Luminent Mortgage Capital Inc. access to $640 million in loans to buy top-rated mortgage-backed securities. Now that much cash gets the firm no more than $80 million. ‘There’s nobody out there trying to lend money on securities,’ said Luminent CEO Trezevant Moore. Six lenders are offering five times leverage… while a year ago, 20 banks extended 33 times, he said. Wall Street firms, reeling from $146 billion in losses on their debt holdings, are fueling a credit crisis by clamping down on lending to investors and hedge funds that use borrowed money to purchase securities.”
February 21 – Bloomberg (Christopher Condon and Michael McDonald): “State regulators are scrutinizing sales of auction-rate securities by closed-end mutual funds as investors complain they can’t get out of the investments, which were billed as the equivalent of cash. Massachusetts Secretary of State William Galvin asked nine fund companies for information about failed auctions that left investors unable to sell their holdings, his office said in a statement yesterday. Ohio Attorney General Marc Dann may file lawsuits after state funds bought the securities, spokeswoman Jennifer Brindisi said yesterday in an e-mail. ‘I wanted something as good as cash, and now I’ve got a lot of money in there that I needed to get at quickly,’ Aaron E. Some, an investor in Delray Beach, Florida, said… The investor said he has $4.5 million tied up in auction-rate securities issued by closed-end funds.”
February 21 – Bloomberg (Hugh Son): “MasterCard Inc., the second-biggest payment-card network, said it may be unable to sell about $252 million in auction-rate securities because of a ‘failure’ of the bidding mechanism… ‘There may be no effective mechanism’ for selling the securities, which are collateralized by U.S. student loans, the firm said.”
February 20 – Financial Times (Robert Cookson and Gillian Tett): “International regulators are stepping up pressure on the financial industry to introduce a clearer system for settling contracts after a corporate default in the $45,000bn credit derivatives market. In particular the New York Federal Reserve and UK’s Financial Services Authority are urging industry associations such as the International Swaps and Derivatives Association…to introduce binding rules about how credit default swaps (CDS) contracts are settled in default. The moves come amid growing expectations that corporate bond default rates will rise sharply in the next couple of years. It also comes amid signs that some mainstream investors are becoming uneasy about the ability of the CDS infrastructure to withstand a wave of defaults – particularly as settlement procedures are still relatively untested. Settlement has become a particular concern because the CDS market has expanded so dramatically this decade that the volume of derivatives contracts can sometimes be ten times bigger than the underlying cash bonds on which the CDS are based.”
February 20 – The Wall Street Journal (Rob Curran): “Options can offer investors protection against sharp moves in the value of their stock. But some observers think surging demand for options may be increasing the frequency of big market swings. Through options, investors get the right to buy or sell stock at fixed prices. The Wall Street banks that broker those deals end up taking the other side of the trade. If their clients make money, the banks lose. To offset that exposure, banks have to ‘delta hedge.’ That means selling stock when clients make bets that prices will fall and buying stock when clients stake out positions that will pay off if prices rise. The more a stock rises or falls, the more a bank must buy or sell to hedge its risk. As a result, brokers are buying when markets rise and selling when they fall, and they're doing so in greater volumes. That may well be exacerbating stock moves in each direction, said Lars Kestner, a managing director in equity derivatives at Deutsche Bank…”
February 21 – Bloomberg (Jody Shenn): “Bank of America Corp., Citigroup Inc., and the eight other U.S. commercial banks with the largest portfolios of mortgage-backed securities boosted holdings of ‘non-agency’ home-loan bonds by $48 billion last quarter as prices were tumbling, according to Barclays Plc analysts.”
February 21 – Bloomberg (Pierre Paulden): “The ratio of high-risk, high-yield loans trading at distressed levels has surged to 8.13%, the highest in five years, from 4.65% at the end of January, according to Wachovia Corp. Distressed loans, defined as those that trade below 80 cents on the dollar, may have a 25% chance of defaulting within a year…”
February 22 – Bloomberg (David Mildenberg): “GMAC LLC, the lender partially owned by General Motors Corp., agreed to loan as much as $750 million to its residential mortgage unit as it seeks to sell a business that finances vacation resorts. Residential Capital LLC borrowed $635 million under the agreement yesterday…”
February 20 – Bloomberg (Bryan Keogh): “A record 41 companies with high-yield, high-risk credit ratings are in danger of breaching terms of their loan agreements within 12 months as the slowing economy cuts into corporate profits, Moody’s… estimates.”
February 18 – Bloomberg (Gonzalo Vina and Jon Menon): “Northern Rock Plc, which suffered the first run by U.K. bank depositors in more than a century, may remain nationalized for years to come, according to the chairman appointed by Prime Minister Gordon Brown’s government. ‘We are clearly talking about a period of some years,’ Ron Sandler…said…”
Currency Watch:
The dollar index fell 0.8% this week to 75.52. For the week on the upside, the Brazilian real increased 1.9%, the New Zealand dollar 1.8%, the Norwegian krone 1.6%, the Swiss franc 1.6%, the Swedish krona 1.3%, the Taiwanese dollar 1.3%, and the Euro 1.2%. On the downside, the South African rand declined 1.5%, the Canadian dollar 0.5%, and the South Korean won 0.4%.
Commodities Watch:
February 22 – China Knowledge (Kartik Goyal): “China has surpassed the U.S. and Turkey as the world’s second largest market for gold jewelry, only next to India, according to… the World Gold Council. Gold sales in the Greater China area, including Hong Kong, Macau and Taiwan totaled 363.3 tons during last year, surging 23% from a year earlier…”
February 19 – Bloomberg (Tony Dreibus and Jeff Wilson): “The biggest rally in the history of wheat trading defied even some of the best conventional wisdom, humbling forecasters from Goldman Sachs Group Inc. to the U.S. government. Wheat has more than doubled since May, reaching a record $11.53 a bushel on Feb. 11 and driving up costs for everything from Eggo waffles and Italian pasta to Pakistani flatbreads and Japanese pastry.”
February 19 – Financial Times: “The price of steel is set to rise after Asian and European producers agreed to pay up to 71% more for iron ore in term-contract rates beginning on April 1… The big rise suggests demand for commodities from emerging economies such as China remains strong, offsetting the US slowdown and fuelling fears that global inflation will continue to rise in the short term.”
February 19 – Financial Times (Chris Flood and Javier Blas): “Coffee, cocoa and tea markets are nearing boiling point, with prices at multi-year peaks as supportive demand and supply conditions and fears about foodinflation have fuelled high levels of speculative buying. ‘Tight fundamentals tend to exacerbate speculative investment,’ says Nestor Osorio, executive director of the International Coffee Organisation…”
February 19 – Financial Times (Javier Blas): “Tea prices are likely to jump to an all-time high this year, underpinned by production disruptions in Kenya… In the latest sign of rising global food inflation, wholesale tea prices surged last year to an annual average of $1.95 a kilogram, a 6.5% increase from the previous year and the highest annual level since 2002. Average tea prices “are expected to reach even higher and possibly record levels” in 2008 following a 10% reduction in shipments from Kenya…”
Gold surged 4.8% to $946, and Silver jumped 5.4% to $18.03. May Copper rose 7.5%. April Crude gained $3.64 to $99.09. March Gasoline jumped 3.5%, and March Natural Gas gained 2.1%. March Wheat increased 2.1%. Coffee jumped to a 10-year high, increasing y-t-d gains to 19%. The CRB index surged 3.8% to a new record (up 11.1% y-t-d). The Goldman Sachs Commodities Index (GSCI) rose 3.5% to a new record (up 8.2% y-t-d and 46.8% y-o-y).
China Watch:
February 19 – Bloomberg (Nipa Piboontanasawat): “China’s inflation accelerated to the quickest pace in more than 11 years after the worst snowstorms in half a century disrupted food supplies. Consumer prices rose 7.1% in January from a year earlier… Food prices soared 18% after blizzards paralyzed transport systems and destroyed crops.”
February 22 – Bloomberg (Nipa Piboontanasawat and Li Yanping): “China… said inflation will remain at a high level in the first half of 2008 and the central bank will use interest rates to control prices. China ‘needs to bring out monetary policy to control demand expansion and stabilize inflation expectations,’ the People’s Bank of China said…”
February 21 – Bloomberg (Luo Jun): “Chinese banks face higher bad-loan ratios for the first time since 2003 as corporate defaults may increase because of tighter credit controls and weakening demand from a slowing U.S. economy, Standard & Poor's said. ‘Challenges are looming on the corporate lending front,’ Liao Qiang, a Beijing-based analyst at S&P, said…”
February 20 – Bloomberg (Tian Ying): “China’s passenger car sales rose 19.8% in January on demand ahead of the Chinese new year. Automakers in the country sold a total of 661,900 cars during the period…”
February 19 – Bloomberg (Belinda Cao): “China will explore more channels to invest its $1.5 trillion currency reserves, the world's biggest, for ‘higher returns,’ the central bank said. The government will allow local companies and individuals more leeway to convert their yuan holdings into foreign currencies to invest overseas…”
Japan Watch:
February 22 – Bloomberg (Keiko Ujikane): “Japan’s government lowered its assessment of the economy for the first time in 15 months, saying growth will moderate as exports and production cool.”
India Watch:
February 19 – Bloomberg (Subramaniam Sharma): “Salaries in India are set to rise at the fastest pace in the world this year as a real-estate boom and the addition of capacities spur demand for skilled people, Hewitt Associates Inc. said. Wages in India will rise an average 15.2% this year, the sixth successive annual increase of more than 10%...”
February 22 – Bloomberg (Kartik Goyal): “India’s inflation accelerated more than expected to a six-month high in the first week of February as prices of vegetables, fruits and lentils rose. Wholesale prices climbed 4.35%...from a year earlier…”
Unbalanced Global Economy Watch:
February 20 – Bloomberg (Jennifer Ryan): “U.K. money supply growth unexpectedly accelerated in January, the Bank of England said. M4…rose 12.9% from a year earlier, compared with 12.3% in December…”
February 21 – Bloomberg (Simon Kennedy): “French inflation accelerated in January to the fastest pace in at least 12 years, led by higher food and energy costs. Consumer prices climbed by an annual 3.2%, up from 2.8% in December…”
February 21 – Financial Times (Ralph Atkins): “An inflation-beating 5.2% wage increase secured by German steelworkers… stoked fears that stubbornly high eurozone inflation pressures would prevent the European Central Bank from cutting interest rates in the near future.”
February 21 – Bloomberg (Simone Meier and Joshua Gallu): “Swiss producer and import prices jumped to the highest level in almost 20 years in January, adding to signs that inflation pressure is mounting. Prices for factory and farm goods as well as imports increased 3.7% from a year earlier, the biggest gain since Sept. 1989…”
February 19 – Bloomberg (Christian Wienberg): “Denmark’s government should limit spending as unemployment at a 33-year low threatens to spark a ‘wage spiral’ and push up inflation, the Organization for Economic Cooperation and Development said. ‘Avoiding overheating is an urgent challenge,’ the…OECD said…”
February 22 – Bloomberg (Flavia Krause-Jackson and Giovanni Salzano): “Italy’s inflation rate for frequently bought goods such as food and gasoline surged to the highest since in more than a decade… Consumer prices for frequent purchases jumped 4.8% in January from a year earlier…”
February 19 – Bloomberg (Jacob Greber): “Australian inflation may accelerate to almost 4% as a labor shortage worsens, central bank official Malcolm Edey said… The striking thing is the contrast between domestic and international conditions,’ Assistant Governor Edey told business leaders… ‘The Australian economy to date has stayed robust and the main domestic challenges are those of strong demand, tight capacity and inflationary pressures.’”
Latin America Watch:
February 20 – Bloomberg (Matthew Craze): “Argentine truck drivers negotiated a 19.5% wage increase with the government and their employers, setting a precedent for wage talks with other salaried workers in the South American country.”
Central Banker Watch:
February 19 – Bloomberg (Francois de Beaupuy): “The Bank of France said the U.S. Federal Reserve may have cut interest rates too much and too quickly in response to financial-market declines. An unsigned article in the…bank’s monthly bulletin…said new financial products have amplified asset price swings. That may lead to ‘stronger Monetary reactions than what would otherwise be necessary, as shown by the recent decision of the Federal Reserve…’ The unusual criticism by one central bank of another may reflect the European Central Bank's reluctance to follow its U.S. and U.K. counterparts in cutting rates…”
Bursting Bubble Economy Watch:
February 21 – The Wall Street Journal (Greg Ip): “The U.S. faces an unwelcome combination of looming recession and persistent inflation that is reviving angst about stagflation, a condition not seen since the 1970s. Inflation is rising. Yesterday the Labor Department said consumer prices in the U.S. jumped 0.4% in January and are up 4.3% over the past 12 months, near a 16-year high… A simultaneous rise in unemployment and inflation poses a dilemma for Fed Chairman Ben Bernanke. When the Fed wants to fight unemployment, it lowers interest rates. When it wants to damp inflation, it raises them. It's impossible to do both at the same time.”
GSE Watch:
February 22 – Bloomberg (Jody Shenn): Freddie Mac, the second-largest provider of money for U.S. home loans, implemented new fees for ‘higher risk’ debt it buys or guarantees and said it will no longer accept most mortgages that exceed 97% of a home’s value.”
Mortgage Finance Bust Watch:
February 20 – Bloomberg (Alison Vekshin): “U.S. savings and loans posted a record $5.24 billion loss in the fourth quarter of 2007 as housing-market distress continued to take a toll… The loss stemmed from $4.07 billion in ‘goodwill’ writedowns and $5.12 billion set aside for anticipated loan losses, the Treasury Department’s Office of Thrift Supervision said… ‘Looking forward, I think 2008 is going to be a very difficult year for the industry,’ OTS Director John Reich said.”
Muni Watch:
February 19 – Bloomberg (Michael McDonald): “Drivers on the Massachusetts Turnpike may face higher tolls after the state was unable to sell auction-rate securities backed by a unit of Ambac Financial Group Inc. The Massachusetts Turnpike Authority was forced to delay refinancing $126.7 million it borrowed for the ‘Big Dig’ because it bought bond insurance from troubled Ambac… The state agency is spending an additional $300,000 in interest a month as a result….”
California Watch:
February 20 – Bloomberg (William Selway): “California Governor Arnold Schwarzenegger ordered state agencies to stop hiring and scrap new equipment purchases as part of a plan to save $100 million this year and help close a budget shortfall… The order follows lawmakers' Feb. 15 passage of measures to cut about $1 billion from this year’s budget as revenue growth slows… Before the spending cuts, California faced a $14.5 billion deficit through June 2009.”
February 20 – Bloomberg (Michael B. Marois): “California’s budget deficit widened to $16 billion as the housing slump and higher energy costs cut tax revenue, the state’s fiscal analyst said. The deficit is $2 billion larger than what Governor Arnold Schwarzenegger predicted in January… Fitch Ratings has warned that California’s credit ratings on $49 billion of debt are in danger.”
February 21 – Bloomberg (Michael B. Marois): “California, the biggest borrower in the U.S. municipal bond market, will replace $1.25 billion of auction-rate bonds with traditional debt after a series of auction failures nationwide sent rates soaring.”
February 21 – Bloomberg (Michael B. Marois): “Vallejo, California, may become the first city in the state to file for bankruptcy should labor negotiations fail to cuts costs before officials run out of money by May 1... ‘This is a last resort,’ City Councilwoman Stephanie Gomes, referring to bankruptcy, said… ‘We’re in a state of crisis here. This isn’t a threat.’”
Fiscal Watch:
February 22 – New York Times (Edmund L. Andrews and Louis Uchitelle): “ Prodded in part by some of the nation’s biggest banks, the Bush administration and Congress are considering costly new proposals for the government to rescue hundreds of thousands of homeowners whose mortgages are higher than the value of their houses. Not since the Depression has a larger share of Americans owed more on their homes than they are worth. With the collapse of the housing boom, nearly 8.8 million homeowners, or 10.3% of the total, are underwater. That is more than double the percentage just a year ago, according to a new estimate of the damage by Moody’s Economy.com. Administration officials say they still oppose any taxpayer bailout for either people who borrowed more than they could afford or banks that made foolish loans… But with the current efforts to arrest the housing collapse so far bearing little fruit, Washington is being forced to explore new ideas, among them the idea of a federal mortgage guarantee for troubled borrowers.”
Speculator Watch:
February 21 – Bloomberg (Tomoko Yamazaki): “Hedge funds around the world had the worst month in at least eight years in January as equities worldwide tumbled amid concerns that the U.S. economy was headed for a recession… The Eurekahedge Hedge Fund Index, which tracks the performance of 2,467 funds that invest globally, dropped 3.3%, based on preliminary figures…”
February 22 – Financial Times (Henny Sender): “New York hedge fund DB Zwirn & Co is winding down its principal funds after investors – rattled by lapses in internal controls… – said they would withdraw more than $2bn. Investors started pulling their money after the group, which has almost $5bn under management, disclosed in March last year that an independent internal review had uncovered improper transfers among funds and improper handling of operational expenses… On Thursday night, Zwirn sent a letter to investors outlining its plans to liquidate assets, about 60% of which are not easily tradable and mostly involve illiquid loans made both in the US and abroad.”
February 21 – Dow Jones (Kaja Whitehouse): “Two China-focused hedge funds that returned 100% or more last year posted double-digit percentage losses in January, tripping over continued volatility in China’s stock market. The 788 China Fund…lost 39.5% in January, following gains of 115% last year… The Golden China Fund…lost 21.5% in January, following gains of 100.3% last year…”
Crude Liquidity Watch:
February 20 – Bloomberg (Matthew Brown): “Inflation in the Middle East may be stoked by recent snowstorms in China that damaged wheat crops, said Royal Bank of Scotland Group Plc. The Middle East is the world’s largest importer of wheat, so any increase in the price of the commodity will fuel food prices… ‘Wheat prices are already a serious problem for the Middle East, while recent snowstorms in China may aggravate the problem,’ Simpfendorfer said… ‘This risk underscores our view that the Middle East economies will continue to face serious inflation risks, so the case for adopting basket pegs or permitting faster appreciation is strong.’”
February 19 – Bloomberg (Matthew Brown): “Mortgage lending growth in the United Arab Emirates slowed to an annual 83% at the end of the third quarter from 97% in the second quarter. Loan and overdraft growth remained at 25% in the third quarter… M3 money supply growth slowed to 34%...”
Confirmations:
There have been several key CBB themes for early 2008. First, expect Credit problem-associated economic weakness to gain momentum. Second, we’re witnessing the evolving “Breakdown of Wall Street Alchemy.” Third, watch for especially atypical Federal Reserve-induced “reflation” dynamics. Fourth, the year will likely mark the bursting of the “leveraged speculating community” Bubble. And, fifth, the unfolding Credit Crisis will become especially problematic as it converges toward our system’s functional “money” supply – the anchor of our monetary system. This week saw important Confirmations with respect to all of the above.
Economic weakness related to faltering Availability of Credit and Marketplace Liquidity has been especially prominent in the data of late. This week was no exception. The February reading for the Philadelphia Fed index sank to the lowest level since February 2001. January Housing Starts were reported near the weakest levels since the early nineties’ recession, while early February auto sales are said to the running 16% below last year’s level. Out in California, dwindling state revenues led legislative analysts to raise the estimate of the state’s budget shortfall to an alarming $16bn, an increase of $1.5bn from last month’s guesstimate.
Despite the faltering U.S. economy, pricing pressures are accelerating – a dynamic I’ve heard referred to as the “new conundrum.” January Consumer Prices were up 4.3% y-o-y. Major commodity price indexes surged to yet new record highs and, if anything, inflationary pressures are broadening. I’ve suggested that this “reflation” will have consequences divergent from those of the past. With the historic Bubble in “Wall Street finance” now bursting, the powerful monetary mechanism linking Fed rate cuts directly to asset price inflation (in particular, real estate, risky debt, and stocks) has been severely impaired if not completely severed. The link between U.S. interest rates, dollar devaluation, faltering confidence in currencies in general, and inflating commodities prices has never been stronger.
During the 2001-2003 “reflation”, hedge fund managers were quoted as saying “the Fed wanted me to buy stocks and junk bonds.” Today, the Fed would surely hope to send a similar message, while the sophisticated interpret things altogether differently. Today, investors and speculators alike are much keener to buy precious metals, energy, and commodities. And while the U.S. economy is succumbing to powerful recessionary forces, it is no longer the sole global engine of (Credit and economic) growth.
It’s worth repeating that global Credit expansion remains brisk, while Bubble dynamics and economic growth remain in place throughout Asia, the Middle East and in the “emerging economies,” especially for the powerful boom in Bric countries ( Brazil, Russia, India and China). In concert with the bursting of the Wall Street Bubble, global inflationary dynamics now strongly favor “things” as opposed to securities. In particular, necessities and Stores of Value available in relatively limited supply are seeing extraordinary inflationary effects.
Here we see one of the key dynamics (Monetary Processes) differentiating the current “reflation” from those of the past: Previous "Wall Street finance"-dominated inflationary booms enveloped the securities markets, where the supply of stocks and bonds could be readily expanded to meet booming demand. Today, the world is faced with a very challenging prospect of increasing the supply of crude, natural gas, ethanol, precious metals, industrial metals, wheat, soybeans, grains, coffee, cocoa, tea and literally scores of things now in great demand by end users, investors, and a bloated leveraged speculating community. Keep in mind that foreign official reserves have inflated $1.35 TN over the past year – and the U.S. is still on track for yet another year of massive Current Account Deficits. Recognize also that the hedge fund and sovereign wealth fund communities have ballooned to the multi-trillions. U.S. deficits and resulting dollar devalulation continue to spur unwieldy Bubbles in China, India, the Middle East and elsewhere.
The bottom line is the world remains awash in dollar liquidity that many are content to exchange for tangible things deemed of greater value than suspect U.S. financial assets. There is no inflation “conundrum,” only increased supply constraints and bottlenecks, global hoarding, and an unambiguous speculative fever in markets for many of our economy’s basic necessities.
This week provided Confirmation of a worsening backdrop for the leveraged speculating community.
February 22 – Bloomberg (Hamish Risk): “Mathematical models that traders use to calculate prices in the $2 trillion market for collateralized debt obligations don’t work anymore, according to UBS AG. The so-called correlation model, which shows the odds of one default by an investment-grade company spreading to others in a group, now exceeds 100%...said Geraud Charpin, a structured credit strategist at UBS… ‘The banks realize the model doesn’t work and it needs to be changed,’ Charpin said… Banks are changing the model by reducing the amount of money they expect to recover when a company defaults to 30% from 40%. That means they have to protect against bigger potential losses by purchasing more credit-default swaps, driving prices of the contracts to the highest on record.”
And the breakdown in models is anything but limited to CDOs and the banking community. Bloomberg today reported that AQR Capital Management, manager of $35bn of assets, has suffered significant losses to begin the year. Its largest hedge fund is said to be down 15% already, with slightly larger losses for at least one of its smaller funds. This wasn’t supposed to happen, and I’ll take this development as important Confirmation that troubles that hit the “quant” fund community this past summer have worsened significantly so far this year.
August was a terrible month for model-based quantitative strategies, although most funds quickly recovered much of their losses as the markets stabilized in the fall. This time, however, I do not expect the environment to accommodate. Last summer’s hope that the situation was a short-term aberration has been replaced with this year’s reality of Bursting Bubbles, Credit quagmires, model breakdowns, hopelessly crowded trades, acute marketplace illiquidity and, it would appear, highly problematic fund redemptions. Importantly, the game of leveraged speculation – albeit “quant’ fund strategies, “market neutral,” or “global macro” – works wonderfully only for as long as the industry enjoys (as it had for years) robust inflows.
A steady flow of incoming funds for years ensured ample liquidity to build positions, press bets, increase leverage, and bolster the perception of endless marketplace liquidity, while working to boost industry returns (and overheated expectations). A reversal of flows – especially when abrupt and significant in scope – would pose quite a dilemma for individual funds, the industry overall, and the impaired U.S. Credit system. It will be interesting to follow how the “quant” types respond to an environment of model breakdown, losses, redemptions, and forced position unwinds. I have a hunch they are not well “programmed” for such a radical change in the environment. We can only speculate at this point as to whether the industry is on the precipice of major redemptions.
February 22 – Financial Times (Henny Sender): “New York hedge fund DB Zwirn & Co is winding down its principal funds after investors – rattled by lapses in internal controls… – said they would withdraw more than $2bn. Investors started pulling their money after the group, which has almost $5bn under management, disclosed in March last year that an independent internal review had uncovered improper transfers among funds and improper handling of operational expenses… On Thursday night, Zwirn sent a letter to investors outlining its plans to liquidate assets, about 60% of which are not easily tradable and mostly involve illiquid loans made both in the US and abroad.”
DB Zwirn obviously has its own issues. But it would provide an interesting case study in fund dynamics. At one point, it was a booming fund group with a stellar reputation, stellar returns, 15 offices worldwide and more than 1,000 employees. It is now suffering catastrophic unwinding, faced with the specter of huge redemptions and illiquid positions (including Credit derivatives). Apparently some positions will take up to four years to unwind. Investors that believed they had the option to redeem their interests now confront the likelihood of significant losses and long delays in the return of their capital. I suspect this will be an increasingly common industry predicament.
Throughout the markets, this week provided further Confirmation of serious liquidity constraints. The unfolding Breakdown in Wall Street Alchemy was underscored by further issues with SIVs and the auction-rate securities fiasco. Many individuals, funds, and corporations that believed they had invested in safe and liquid (“money"-like) “cash equivalents” now instead hold illiquid positions in long-term debt instruments of varying quality.
February 22 – Reuters: “Ethanol maker Aventine Renewable Energy Holdings Inc warned on Friday it may be forced to delay construction of two new plants because some of its assets have become unexpectedly tied up in investment securities… Aventine… said it may not be able to sell its investments in auction-rate securities (ARS), forcing it to draw on revolving bank debt or delay work on the plants that are expected to begin operating early next year… Aventine’s securities carry AAA ratings and are backed by federal student loan guarantees. Chief Financial Officer Ajay Sabherwal said the company would not immediately try to sell them into the moribund auction market, but would likely need to do so in the next few months. ‘Should we not be able to liquidate a substantial portion of the remaining portfolio of these ARS securities on a timely basis and on acceptable terms, we will have to either attempt to raise additional funds or slow down the construction of our new facilities, or both…’”
February 22 – Dow Jones (Michael Rapoport): “No one knows for sure who the next Bristol-Myers Squibb Co. might be, but one thing’s for sure: There’s no shortage of candidates. Dozens of companies have warned of potential problems with their holdings of auction-rate securities, a survey by Dow Jones Newswires has found… The market for these securities has seized up recently, prompting some companies that hold them, like Bristol-Myers, to write down their value. Beyond those dozens, other companies, including some big names, hold large amounts of these securities… Without buyers, the securities aren’t liquid. And since many companies classify them as short-term ‘available-for-sale’ investments that are supposed to be marked to market… As it happens, some auditors and their clients had a dispute a few years ago about whether to treat auction-rate securities as equivalent to cash… FASB ultimately decided not to address the issue of how to account for the auction-rate securities. A lot of holders of the securities are probably wishing they had that same option right now.”
I have in past analysis suggested that the perceived soundness of U.S. corporate balance sheets was extending a “hook” for those of the bullish persuasion. It was, after all, egregious Mortgage Finance Bubble excesses - and resulting Household and Financial Sector balance sheets loaded with debt – that were responsible for booming corporate cash-flows and relatively stable balance sheets. Well, these days it is becoming increasingly apparent that a significant portion of corporate America’s “cash” hoard is stuck in “auction-rate securities” and various other Credit instruments - today offering little in the way of actual liquidity. This is now a major unfolding issue.
Scores of companies, previously believing they enjoyed easy access to new finance, now face the inability to raise new funds at any cost. At the same time, many companies that thought they were sitting on piles of safe and liquid financial resources now recognize they may instead be facing big losses. Moreover, the recognition of problems on both the Asset and Liability side of corporate balance sheets comes concurrently with the realization that the so-called sound and resilient U.S. economy is in serious trouble. Simultaneously, confidence in “money” and money-raising is faltering, with negative ramifications for already liquidity-challenged markets and the already weakened real economy.
There is a confluence of factors behind this week’s major widening in corporate spreads, especially in the “safest” sectors. Major indices of investment grade Credit spreads blew out to record wide levels. The “CDX” index widened 12 bps to a record 157 bps, increasing its three-week gain to 50 bps. Agency debt spreads widened 2 bps to the widest level since last November. Yet GSE MBS spreads were this week’s eye-opener. Fannie Mae benchmark MBS spreads surged another 17 bps to 192, the widest spreads in eight years. For perspective, this spread has averaged 76 bps since the end of 2002.
I will take the dramatic widening in investment grade and agency spreads as Confirmation that the unfolding Credit Crisis has made a major leap toward the heart of the Credit system. I have no way of knowing to what degree widening spreads are being dictated by “technical” hedging-related trading dynamics, as opposed to fundamental issues with respect to the faltering U.S. economy; rapidly deteriorating corporate balance sheets; a highly susceptible leveraged speculating community; the vulnerable GSEs; a distressingly illiquid Credit market; and heightened systemic risk more generally. To be sure, a strong case can be made that the current backdrop is quite detrimental to a highly leveraged and speculative Credit system. The markets rallied late this afternoon – and perhaps they will rally further next week – on talk of a bailout for troubled Ambac. Unfortunately, there has been ample Confirmation that the Evolving Credit Crisis has quickly spiraled way beyond the “monolines.”
