Thursday, October 2, 2014

11/09/2007 Fannie in Her Own Words *

For the week, the Dow was slammed for 4.7% (up 4.1% y-t-d) and the S&P500 3.7% (up 2.5%). The Transports fell 4.1% (up 1.0%), and the Morgan Stanley Cyclical index sank 4.7% (up 11.4%). The Utilities added 0.6% (up 13.9%), while the Morgan Stanley Consumer index declined 1.1% (up 4.9%). The small cap Russell 2000 dropped 3.2% (down 1.9%), and the S&P400 Mid-Cap index fell 2.8% (up 7.1%). Technology highflyers came back to earth. The NASDAQ100 sank 8.1% (up 15.8%), and the Morgan Stanley High Tech index dropped 8.4% (up 8.5%). The Semiconductors lost 4.5% (down 6.6% y-t-d). The Internet Index slumped 7.1% (up 13.8%), and the NASDAQ Telecommunications index was hammered for 10.5% (up 11.6%). The Biotechs fell 2.8% (up 6.6%). The Broker/Dealers sank 5.3% (down 13.8% y-t-d), and the Banks declined 3.0% (down 20.3%). Although Bullion jumped $24.70, the HUI Gold index increased only 0.6% (up 30.7%).

Three-month Treasury bill rates collapsed 38 bps this week to 3.27%. Two-year government yields dropped 27 bps to 3.405%. Five-year yields fell 20 bps to 3.75%. Ten-year Treasury yields declined 10 bps to 4.22%, and long-bond yields declined one basis point to 4.60%. The 2yr/10yr spread ended the week at 78.5, the high since April '05. The implied yield on 3-month December ’08 Eurodollars dropped 15 bps to 3.885%. Benchmark Fannie Mae MBS yields rose 4 bps to 5.80%, this week dramatically under-performing Treasuries. The spread on Fannie’s 5% 2017 note widened (to the new 10-year) to 62.4, and the spread on Freddie’s 5% 2017 note widened to 62.3. The 10-year dollar swap spread increased a notable 7.25 to 76, the high since the August crisis. Corporate bond spreads widened, as the spread on an index of junk bonds ended the week 35 bps wider.

November 9 – Bloomberg (Bryan Keogh): “Guitar Center Inc., Hyundai Motor Co. and four other borrowers canceled bond offerings this week as yield premiums surged and investors fled to the relative safety of government securities. Sales slowed to $11.1 billion, the lowest in two months…”

November 5 – Financial Times (David Oakley): “Bond issuance by the world’s biggest banks has plunged in the past week as concerns grow over further balance sheet losses because of the credit squeeze. There have been only 11 bank bond deals since Monday last week - a third of the number of deals priced in the previous week as some financial institutions are forced to stay on the sidelines… according to Dealogic.”

November 9 – Bloomberg (Jeremy R. Cooke): “Puerto Rico and Miami-Dade County postponed municipal bond offerings, deterred by rising benchmark interest rates and slack investor demand as state and local government debt declined for a third week.”
Investment grade debt issuers included Abbott Labs $3.5bn, News America $1.25bn, Northern Trust $400 million, Praxair $400 million, and Public Service Oklahoma $250 million.

Junk issuers included Terex $800 million, McMoran Exploration $300 million, Reable Therapeutics $575 million, Mashantucket Pequot $550 million, and Bristow Group $350 million.

Foreign dollar bond issuance included Ukraine $700 million and BR Malls $175 million.
German 10-year bund yields fell 9 bps to 4.085%, while the DAX equities index slipped 0.5% for the week (up 18.4% y-t-d). The Japanese “JGB” market dropped 8 bps to 1.52%. The Nikkei 225 was clobbered for 5.7% (down 9.5% y-t-d). Most emerging debt and equities markets came under pressure this week. Brazil’s benchmark dollar bond yields rose 9 bps to 5.81%. Brazil’s Bovespa equities index added 0.4% (up 44.6% y-t-d). The Mexican Bolsa sank 5.3% (up 10.2% y-t-d). Mexico’s 10-year $ yields jumped 14 bps to 5.49%. Russia’s RTS equities index gained 1.9% (up 17.7% y-t-d). India’s Sensex equities index dropped 5.4% (up 37.1% y-t-d). China’s Shanghai Exchange fell 8.0%, reducing y-t-d gains to 99% and 52-week gains to 180%.

Freddie Mac posted 30-year fixed mortgage rates dipped 2 bps this week to 6.24% (down 9bps y-o-y). Fifteen-year fixed rates declined one basis point to 5.90% (down 14bps y-o-y). One-year adjustable rates fell 7 bps to 5.50% (down 5bps y-o-y).

Bank Credit surged $39.2bn during the week (10/31) to a record $9.109 TN. Bank Credit has now posted a 15-week gain of $466bn (18.7% annualized) and y-t-d rise of $812bn, a 11.6% pace.For the week, Securities Credit jumped $22.7bn. Loans & Leases increased $16.5bn to a record $6.685 TN (15-wk gain of $360bn). C&I loans rose $5.5bn, increasing 2007's growth rate to 20.8%. Real Estate loans grew $4.1bn. Consumer loans slipped $2.9bn. Securities loans dropped $13.1bn, while Other loans jumped $22.9bn. On the liability side, (previous M3) Large Time Deposits jumped $48.4bn (4-wk gain of $138bn).

M2 (narrow) “money” surged $44.5bn to a record $7.427 TN (week of 10/29). Narrow “money” has expanded $384bn y-t-d, or 6.4% annualized, and $478bn, or 6.9%, over the past year. For the week, Currency increased $1.2bn, while Demand & Checkable Deposits gained $5.0bn. Savings Deposits jumped $34.8bn (2-wk gain of $56.3bn), and Small Denominated Deposits added $1.7bn. Retail Money Fund assets increased $1.9bn.

Total Money Market Fund Assets (from Invest. Co Inst) jumped $54.6bn last week, surpassing $3.0 TN for the first time. Money Fund Assets have now posted an unprecedented 15-week gain of $417bn (56% annualized) and a y-t-d increase of $619bn (30% annualized). Money fund assets have posted a 52-week gain of $728bn, or 32%.
Total Commercial Paper fell $15.7bn to $1.867 TN. CP is down $357bn over the past 13 weeks. Asset-backed CP dropped $16.8bn (13-wk drop of $304bn) last week to $869bn. Year-to-date, total CP has dropped $108bn, with ABCP down $215bn. Over the past year, Total CP has declined $34bn, or 1.8%.

Asset-Backed Securities (ABS) issuance slowed to a paltry $3.0bn this week. Year-to-date total US ABS issuance of $505bn (tallied by JPMorgan) is running 35% behind comparable 2006. At $217bn, y-t-d Home Equity ABS sales are 55% off last year’s pace. Year-to-date US CDO issuance of $280 billion is now 10% below comparable 2006.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 11/7) increased $0.3bn to a record $2.033 TN. “Custody holdings” were up $280bn y-t-d (18.5% annualized) and $337bn during the past year, or 19.8%. Federal Reserve Credit expanded $1.7bn to $864bn. Fed Credit has increased $12.2bn y-t-d and $29.1bn over the past year (3.5%).
International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $1.127 TN y-t-d (27% annualized) and $1.236 TN year-over-year (26%) to $5.937TN.

Credit Market Dislocation Watch:

November 9 – Bloomberg (Neil Unmack): “More than $350 billion of collateralized debt obligations comprising asset-backed securities may become ‘distressed’ because of credit rating downgrades, Morgan Stanley said… ‘The pace of ABS CDO downgrades will pick up significantly over the next few weeks,’ wrote analysts led by Vishwanath Tirupattur… ‘Given the degree of market dislocations and the potential size of the market, there is clearly an opportunity for attentive investors.’ Moody’s…, Standard & Poor’s and Fitch Ratings have downgraded 856 portions of debt based on asset-backed securities this year because of rising defaults on subprime mortgages. Losses on U.S. home loans may reach $250 billion in the next five years, analysts at Lehman Brothers Holdings Inc. wrote…”

November 7 – Bloomberg: “ reports that U.S. banks and brokers face as much as $100 billion of writedowns because of Level 3 accounting rules, in addition to the losses caused by the subprime credit slump, according to Royal Bank of Scotland Group Plc. The Financial Accounting Standards Board’s rule 157 will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, Royal Bank’s Chief Credit Strategist Bob Janjuah…wrote… ‘This credit crisis, when all is out, will see $250 billion to $500 billion of losses,’ …Janjuah said. ‘The heat is on and it is inevitable that more players will have to revalue at least a decent portion’ of assets they currently value using ‘mark-to-make believe.’ Morgan Stanley has the equivalent of 251% of its equity in Level 3 assets… Goldman Sachs Group Inc. has 185%, Lehman Brothers Holdings Inc. has 159% and Citigroup Inc. has 105%, Janjuah wrote.”

November 7 – Financial Times: “‘Nothing will come of nothing,’ railed King Lear. And we all know what happened to him. The quote is apt when looking at supposedly safe tranches of collateralised debt obligations… These securities were supposedly so safe that Citigroup’s $43bn drawer-full did not even merit a mention a few weeks ago. Now they are the main cause of a potential $8bn to $11bn writedown. In CDO-land, a security that sits right at the top of the capital structure does not imply its collateral is safe. It just means that there are a lot of other securities below it, which will absorb initial losses. The danger is that this cushion is not much protection if the underlying collateral turns to dust… The latest Citi blow contained three scary nuggets. The first is nobody really knows where the CDO debacle will lead. The complexity of valuing these things - not just how the cash from the underlying collateral gets divvied up but how the the default rates of the different securities correlate - was underscored by the $3bn range Citi attached to its potential hit. The second is that the scale of the mess could be even greater since there are many synthetic CDOs out there referencing the cash CDOs. Lastly, Citi added yesterday for good measure that all it had detailed was its direct exposure. Along with others, it may have offloaded credit risk to bond insurers. If those guarantees were to lose value, that could be an additional concern.”

November 7 – Financial Times: “Do banks have enough capital to withstand continuing bombardment from the credit markets? The scale of writedowns in the third quarter, further deterioration in structured finance markets since then and accelerating credit downgrades suggest some may not. There are two categories of banks that could prove vulnerable: banks that started out with low Tier 1 ratios, and those that appear adequately or even well-capitalised but have been hit particularly hard by exposure to structured finance products… Rating downgrades are likely to add to the pain, by forcing sales at markdowns or requiring more capital to be held against these weakened assets. Standard and Poor’s has so far downgraded just $47bn of the $1,000bn of subprime CDOs it has rated since 2005, for example.”

November 7 – Financial Times (David Wighton, Saskia Scholtes and Gillian Tett): “The risk of fire sales of securities was rising on Tuesday after rating agencies declared that a clutch of complex debt vehicles had defaulted and signs emerged that the ‘superfund’ plan backed by the US Treasury had stalled. The developments are likely to raise investor fears and increase pressure on US authorities to take measures to shore up sentiment in the credit world… The $75bn superfund plan…seems to be on ice following the upheaval at Citi­group… ‘As far as we can see, it appears dead in the water right now,” said one senior Wall Street banker.’”

November 9 – Bloomberg (Elizabeth Hester): “JPMorgan Chase & Co., the third-largest U.S. bank, said it held $40.6 billion in leveraged loans and unfunded commitments as of Sept. 30 that are difficult to hedge and ‘further markdowns could result if market conditions worsen…’ JPMorgan’s collateralized debt obligations, subprime mortgage holdings and trading positions may fall in the fourth quarter because of market conditions, the bank said. As a result, more money to cover bad loans may have to be set aside.”

November 9 – Bloomberg (Kabir Chibber): “The perceived risk of defaults by banks, brokers and insurers will remain close to the highest in at least five years until 2008, according to Lehman Brothers… Credit-default swaps on Citigroup Inc. jumped to a record 83 basis points this week, a sixfold increase from June… Contracts on Merrill Lynch & Co. have more than doubled in the past month to 135 bps…”

November 9 – Financial Times (Michael Mackenzie, David Oakley and Gillian Tett): “In recent days, the faceless bankers who work in the Treasury departments of some of the world’s largest banks have started to get uneasy as it has become clear that the summer credit crisis is far from over. The angst stems from expectations among investors and banking analysts that more red ink from financials is inevitable. As banks face having to write down further securities, derivatives and credit structures that reference the deteriorating US mortgage market, many fear a protracted period of stress for the financial system. ‘What’s now clear is that the mess is here to stay, and that it’s likely to get worse for homeowners and the banks long before it gets better,’ said William O'Donnell, strategist at UBS. ‘The worst is yet to come, and we are heading into year-end when there is a lack of liquidity,’ said TJ Marta, fixed-income strategist at RBC Capital Markets.”

November 8 – Financial Times (Gillian Tett): “Big investment banks and other institutions will be forced to sharply increase their writeoffs on mortgage-linked assets to $60bn-$70bn in the coming months in a further blow to their weakened financial state, according to their own analysts. The projected losses - $40bn more than the banks have acknowledged so far - came as concerns about the health of US banks escalated yesterday… Shares in Washington Mutual…and Capitol One…plunged after both increased reserves to cover expected loan losses. ‘The soft landing we were anticipating quickly transitioned to a severe downturn,’ said Kerry Killinger, chief executive at Washington Mutual…”

November 6 – Financial Times (Paul J Davies): “In recent days, investors have been presented with a stream of high-profile signs that sentiment in the financial world is deteriorating. However, deep in one esoteric corner of finance, another, little-known set of numbers is provoking growing concern. So-called correlation - a concept that shows how slices of complex pools of credit derivatives trade relative to each other - has been moving in unusual ways… ‘What we are seeing in the synthetic [derivative] markets is that there is a serious fear of systemic risk,’ says Michael Hampden-Turner, credit strategist at Citigroup. ‘This is not just about price correlation within the collateralised debt obligation market, but about a potential rise in default correlation and asset correlation.’ …Until recently, traders often tended to assume that there was relatively little correlation between different chunks of debt, because they thought that the biggest risk to the world was idiosyncratic in nature - meaning that while one company, say, might suddenly default, it was unlikely that numerous companies would default at the same time. However, some regulators have been warning for some time that in times of stress correlation does not always behave as traders might expect.”

November 9 – Financial Times (Paul J Davies): “The funding problems hurting structured investment vehicles are so acute that most managers now do not expect the industry to survive the current crisis, according to Moody’s… The inability of most vehicles to raise short-term debt since the summer is putting even the largest, oldest and most diversified of these vehicles under tremendous strain. It led Moody’s late on Wednesday to put the capital notes of a flood of SIVs on review for possible downgrade… ‘Many managers have told us they now do not expect to see the SIV model survive in its current form,’ said Paul Kerlogue, senior credit officer at Moody’s…”

November 6 – Bloomberg (Christine Richard): “Bond insurers including MBIA Inc., Ambac Financial Group Inc. and ACA Capital Holdings Inc. face ‘massive losses’ over the next few quarters that could test their ability to raise new capital, according to rating company Egan-Jones Ratings Co. MBIA may have losses of $20.2 billion on guarantees and securities holdings, Sean Egan, managing director of Egan-Jones, said… ACA Capital may take losses of at least $10 billion; Ambac Financial Group Inc. may reach $4.3 billion; MGIC Investment Corp. $7.25 billion; and Radian Group $7.2 billion… ‘There is little doubt that the credit and bond insurers face massive losses over the next few quarters and many will be capital challenged,’ Egan said.”

November 8 – Financial Times (Gillian Tett): “A couple of days ago, the Financial Times received a furious complaint from Fitch, the credit ratings group. The reason? The FT recently wrote that Fitch had placed the ratings of monoline insurers on ‘watch’ for possible downgrade. And while the general direction of this report was correct, Fitch hotly objected to FT’s use of the word ‘watch’; instead, its ratings framework for the monolines have apparently been put “on review” – to see if downgrades are needed. No doubt such semantics matter to lawyers or ratings addicts. But to my mind this hair-splitting illustrates a bigger point: namely just how sensitive – if not, paranoid – the ratings agencies have become these days, in the face of the current vast barrage of political and financial pressure… In recent weeks, the share prices of monolines, such as Ambac, have plunged on speculation that their ratings are about to be cut…. the problem that dogs the ratings agencies is that if they downgrade the monolines, this could spark a much wider chain reaction. For the business model of the monolines does not work unless they have a AAA rating (or equivalent.) Or as a non-executive director of one monoline says: ‘The credit rating agencies are like our regulators – they have the power of life and death over us.’ Moreover, a downgrade of the monolines would mean that all the bonds they have guaranteed would be downgraded too.”

November 7 – Financial Times (Joanna Chung, Stacy-Marie Ishmael, Michael Mackenzie and Saskia Scholtes): “Gary Pollack, an investor in the vast and traditionally safe $2,500bn municipal bond market in the US, is starting to fret about the escalating problems in the credit world. In particular, he is worried about a stream of bad news coming from specialist bond insurers… If the bond insurers were to lose their triple-A rating, it would have widespread repercussions for every security they insure. ‘This is the first time that the credit quality of these institutions is being called into question,’ says Mr Pollack, head of fixed income research and trading at Deutsche Bank Private Wealth Management… The US Treasury and municipal bond markets have historically moved together but they diverged since August when the credit squeeze first flared. Banks have also insured muni bonds through so-called tender option bond programmes (TOBs). These issue short-term paper backed by portfolios of long-term municipal debt. The banks guarantee that, if there are any problems with the underlying portfolio, they will pay back the short-term debt. TOBs have been among those hardest hit by credit worries and two of the biggest are run by Citigroup and Merrill Lynch… ‘TOBs account for the lion’s share of demand in the primary market and people are likely to be more reluctant to commit funds to these structures following the recent losses and volatility,’ says Matt Fabian, senior analyst at Municipal Market Advisors…”

November 7 – Dow Jones: “‘The muni market continues to lag Treasurys,’ said Gary Pollack at Deutsche Bank Private Wealth Management, as Treasurys benefit from a flight to quality and ‘while munis continue to have a cloud over them’ because of market uncertainty over bond insurers. In the secondary market, yields are generally 7 to 10 basis points higher on bonds insured by FGIC, MBIA and Ambac. Some bonds for sale are being touted by saying: ‘The bonds are not insured!’ Pollack said.”

November 7 – Bloomberg (Jeremy R. Cooke): “Arizona tax-exempt bonds used to finance a natural-gas supply contract and backed by Citigroup Inc. had their credit rating cut as expected losses linked to subprime debt grew at the largest U.S. bank by assets. Moody’s… cut to Aa2 from Aa1 its rating on $1.23 billion of gas-revenue bonds sold by Salt Verde Financial Corp… Bonds at the longest maturities of the deal have fallen more than 5 cents on the dollar from the prices at which they were sold last month… Tax-exempt bonds backed by Merrill Lynch & Co. and other investment banks also have weakened in recent weeks as firms account for soaring defaults on subprime mortgages.”

November 6 – Financial Times (Joanna Chung and Stacy-Marie Ishmael): “Mounting concerns about the health of stricken bond insurers in the US have started to affect sentiment for related debt on the other side of the Atlantic. Investors holding insured bonds issued by the BBC and Arsenal, the UK football club, and other household name companies have been demanding higher premiums as they lose faith in the bond insurers that have guaranteed the bonds. The risk premium required to hold sterling denominated ‘wrapped’ paper - guaranteed by various US bond insurers - has risen to 10 to 15 basis points above other AAA-rated bonds, compared with a difference of 3bp two weeks ago…”

November 7 – Financial Times (Martin Arnold and James Politi): “Private equity bidders are finding life difficult since the credit squeeze and are walking away from deals, inflating the value of failed buy-outs to $202bn this year - more than double the figure for the same period last year…. One London-based banker said private equity was often looking for a way out of deals agreed before credit conditions turned. ‘They are stuck between a rock and a hard place - either dump the bid and look bad or be stuck with a costly deal,’ he said.”
November 9 – Reuters (Eric Burroughs): “The trustee of a $1.5bn collateralised debt obligation managed by State Street Global Advisors has started selling assets, apparently starting a process of liquidation, Standard & Poor's said… The news from the ratings agency raised worries of similar action on a wider array of structured securities, and stirred more fears about the exposure of U.S. financial institutions to credit markets… S&P said it slashed its ratings on Carina CDO Ltd’s top tranche of securities by 11 notches to the junk level of BB from the top-notch triple-A after it received a notice on Nov. 1 saying that the controlling noteholders had told the trustee to liquidate… S&P said 14 CDOs have received such default notices, twice as many as the agency said had received the notices a week ago…”

November 6 – Bloomberg (Shannon D. Harrington): “Primus Guaranty Ltd., the firm that oversees $20.4 billion in credit-default swaps, fell the most since it became a public company in 2004 as it said the credit-market rout is hampering its ability to sell new debt and roiling $80 million in contracts tied to mortgage securities.”

Currency Watch:

November 7 – Bloomberg (Josephine Lau): “China will invest in stronger currencies when diversifying its $1.43 trillion foreign-exchange reserves, said Cheng Siwei, vice chairman of the National People's Congress. ‘We will favor stronger currencies over weaker ones, and will readjust accordingly,’ Cheng said… The dollar is ‘losing its status as the world currency,’ Xu Jian, a central bank vice director, said… Chinese investors reduced holdings of U.S. Treasuries by 5% to $400 billion in the five months to the end of August…”

November 5 – Bloomberg (Bo Nielsen and Adriana Brasileiro): “Gisele Bundchen wants to remain the world’s richest model and is insisting that she be paid in almost any currency but the U.S. dollar. Like billionaire investors Warren Buffett and Bill Gross, the Brazilian supermodel, who Forbes magazine says earns more than anyone in her industry, is at the top of a growing list of rich people who have concluded that the currency can only depreciate…”

The dollar index fell 1.2% to 75.40. For the week on the upside, the Japanese yen increased 3.4%, the Swiss franc 2.8%, the Norwegian krone 1.6%, the Swedish krona 1.6%, the Danish krone 1.4%, and the Euro 1.4%. On the downside, the Mexican peso declined 1.5%, the Canadian dollar 1.1%, the Australian dollar 1.0%, and the New Zealand dollar 0.8%.

Commodities Watch:

November 8 – Financial Times (Ed Crooks): “Runaway energy demand will have ‘alarming’ consequences, including higher oil prices, threats to - supplies and the acceleration of - climate change, the International Energy Agency warned…The rich countries’ energy watchdog said rapid growth in China and India meant that without a radical change in policies, both countries would double their energy consumption by 2030, putting pressure on scarce resources such as oil and raising emissions of greenhouse gases. To avert those threats, the IEA called for greater investment in nuclear power and renewables, and a drive to improve energy efficiency with policies such as tougher standards for cars and domestic appliances.”

November 7 – New York Times (Mark Landler): “As the price of oil surges toward a symbolic milestone of $100 a barrel — hitting $96.70 yesterday — it is creating new winners and losers across the globe. In southern China, high oil prices forced Wang Pui, a trucker, to wait in line 90 minutes the other day to fill up, just to be told he could pump only 25 gallons, as China faced spot shortages of gasoline and diesel fuel. When Vladimir V. Putin was making Russia’s bid to be host of the 2014 Winter Olympics last July, he reached into the country’s deep pockets, bulging with oil profits, and pledged $12 billion to turn a Black Sea summer resort into a winter-sports paradise. Russia, which was nearly bankrupt a decade ago, won the Games. The prospect of triple-digit oil prices has redrawn the economic and political map of the world, challenging some old notions of power. Oil-rich nations are enjoying historic gains and opportunities, while major importers — including China and India, home to a third of the world’s population — confront rising economic and social costs.”

November 6 – Financial Times (Javier Blas): “Energy consumers and speculators are scrambling to take out options contracts to insure themselves against oil prices rising above $100 a barrel - a further sign of growing expectations of a spike in the crude market. Some have even taken out contracts to protect themselves against prices rising to $250 a barrel within two years. The buying frenzy has been ‘extraordinarily’ strong in the past week… ‘Options calls of strikes well over $100 a barrel are being bought by the thousands,’ said Nauman Barakat of Macquarie Futures… The strong flows in call options - contracts that give the right to buy at a predetermined price and date - are boosting short-term oil prices as the banks that sell them have to hedge their positions by buying crude oil in the futures market, traders said.”

November 8 – Financial Times (Jing Ulrich): “A globalised world is, in many ways, a smaller world. When shoppers scour the grocery store aisles in San Francisco, Sydney or Seoul, they may be purchasing different food items, but these days they are suffering from the same sticker shock. Whether due to drought in Australia or an ethanol boom in the US, the effects on food prices are felt in all corners of the world. In China, soaring food prices have driven inflation to their highest levels in more than a decade, straining household budgets in the world’s most populous country. Dramatic price increases have been chalked up to an unfortunate confluence of factors - supply problems endemic in China’s pork industry, an outbreak of ‘blue ear’ disease on pig farms and to drought and flood-related price hikes. But behind these events, a host of structural problems are contributing to higher prices. China feeds 22% of the world’s people with only 7% of its farmland and must do so with a poor endowment of agricultural resources. Compounding matters, China’s per capita water supply amounts to just a quarter of the global average and is unevenly distributed.”

November 6 – The Wall Street Journal (Lauren Etter): “Agricultural production is struggling to keep pace with demand as diets improve around the world and agricultural products become more central to energy markets, according to a report [from]…Credit Suisse Group. The structural changes in agriculture markets mean commodity prices, and therefore consumer food prices, will continue to stay aloft over coming years… Exacerbating the situation is the advent of biofuels.”

For the week, Gold jumped 3.1% to $831.70, and Silver 6.5% to $15.545. December Copper fell 5.4%. December crude rose 39 cents to a record $96.32. December gasoline added 0.7%, while December Natural Gas declined 6.2%. December Wheat fell 2.1%. For the week, the CRB index added 0.3% (up 15.4% y-t-d). The Goldman Sachs Commodities Index (GSCI) gained 0.4%, increasing 2007 gains to 39.9%.

Japan Watch:

November 6 – Bloomberg (Keiko Ujikane): “Japan’s broadest indicator of the outlook for the economy fell to the lowest level in a decade, signaling growth may stall. The leading index was zero percent in September, the Cabinet Office said…”

China Watch:

November 9 – Bloomberg (Tian Ying and Irene Shen): “China’s passenger car sales rose 21% in October, as a surging stock market boosted consumers’ wealth in the world’s second-largest vehicle market.”

November 7 – Bloomberg (Tom Cahill): “Chinese and Indian crude oil imports will almost quadruple by 2030, creating a supply ‘crunch’ as soon as 2015, the International Energy Agency said. China will replace the U.S. as the world’s largest energy user early next decade and its oil demand will more than double to 16.5 million barrels a day by 2030, led by a seven-fold increase in Chinese car ownership, the IEA said. Together, China and India account for almost half of a projected 55% increase in world energy demand, the IEA estimated… Oil investments of $5.3 trillion will be needed as new sources race slowing output from old wells, the IEA said.”

India Watch:

November 5 – Bloomberg (Cherian Thomas): “India’s tax revenue from companies and personal incomes grew at more than twice the pace forecast for the entire fiscal in the first seven months of the year. Direct tax collection gained 43.2% to 1.28 trillion rupees ($32.8 billion)…”

Asia Boom Watch:

November 7 – Bloomberg (Chinmei Sung): “Taiwan’s exports grew at the fastest pace in nine months in October amid demand for the island’s steel and flat screens used in consumer electronics. Overseas sales rose 14.4% from a year earlier, compared with September’s 10.6% gain…”

November 5 – Bloomberg (Chinmei Sung): “Taiwan’s inflation accelerated to a 13-year high in October on food and energy costs, increasing the likelihood of an interest-rate increase. Consumer prices climbed 5.34% from a year earlier…”

Unbalanced Global Economy Watch:

November 6 – Financial Times (Scheherazade Daneshkhu): “The British economy is beginning to feel the effects of the credit squeeze as activity in retail, services and manufacturing has slowed sharply, according to a clutch of surveys and official data… The service sector grew at its slowest rate in four years, according to a closely watched survey of purchasing managers published yesterday, after a marked slowdown in the financial sector and weaker growth in new orders."

November 9 – Bloomberg (Jennifer Ryan): “The U.K. trade deficit widened to a record in September as exports to countries outside the European Union fell, a sign cooling global economic growth and a stronger pound are sapping demand for British goods. The goods trade gap was 7.8 billion pounds ($16.5 billion), the most since records began in 1697…”
November 5 – Bloomberg (Gemma Daley): “Prime Minister John Howard said there are ‘inflationary pressures’ in Australia. Howard made the comments to Australian Broadcasting Corp. radio…”

November 9 – Bloomberg (Tracy Withers): “New Zealand house sales slumped 23% in October from a year earlier, adding to signs the property market is slowing after interest rates rose to a record.”

November 6 – Bloomberg (Naween A. Mangi): “Pakistan’s credit ratings may be cut by Standard & Poor’s and Moody’s after President Pervez Musharraf imposed emergency rule...”

Latin America Watch:

November 5 – Bloomberg (Adriana Arai and Jose Enrique Arrioja): “Mexico’s central bank Governor Guillermo Ortiz said policy makers can do little to stem rising food prices, and future interest-rate decisions will focus on stopping the spread of inflation to wages and other costs. Increases in the price of wheat, milk and other food items pushed Mexico’s inflation rate above the bank’s 2% to 4% target band… ‘There’s little central banks around the world can do to prevent food prices from rising,’ Ortiz…said…”

Bubble Economy Watch:

November 6 - Financial Times (Eoin Callan): “Large and middle-sized companies in the US are facing tighter lending conditions in the wake of the credit squeeze as the crisis in financial markets spills over into the real economy, a Federal Reserve survey shows. Banks have ‘tightened their lending standards on commercial and industrial loans to large and middle-market firms over the past three months’, the quarterly survey found. The findings underline the risk that the crisis in credit markets will crimp economic activity by compelling companies and consumers to curtail borrowing and spending. The survey ‘provides us with the most comprehensive assessment so far of the impact that the credit crunch is having on US households and businesses and what emerges is a very ugly picture’, said Paul Ashworth, an economist at Capital Economics. The responses from 52 domestic banks and 20 foreign institutions suggest banks stepped up direct lending to companies as an emergency measure when the liquidity crisis first struck over the summer, but are now retrenching.”

November 6 – Bloomberg (Scott Lanman): “Banks made it tougher for American businesses and consumers to borrow in the past three months and said demand for loans slackened, a Federal Reserve survey showed. The changes were most pronounced in real estate, where half of U.S. banks had more-stringent requirements for commercial loans. For home mortgages, 60% of the 40 banks offering nontraditional loans tightened their standards… A ‘notably’ larger group of banks said demand slowed for prime and nontraditional mortgages, the Fed said in today’s report. A net 45% of U.S. banks surveyed said they saw a drop in new ‘jumbo’ home mortgage loans for prime customers, as they made changes such as raising loan fees and minimum down-payments.”

November 9 – Financial Times (Jonathan Birchall): “US retailers sounded the alarm yesterday over the prospects for Christmas sales, after economic worries and warm weather produced a disappointing October. Mike Ullman, chief executive of JC Penney, said his mid-range department store chain expected ‘the challenging retail environment to continue for the foreseeable future…Our customers are clearly facing headwinds that are impacting both sentiment and discretionary spending levels,’ he said, citing the weak housing market, high energy prices, and the uncertainty in the mortgage and credit markets.”

November 8 – Financial Times (Francesco Guerrera and Michael MacKenzie): “Wall Street analysts are rapidly losing faith in US companies’ ability to rekindle profit growth before the end of the year, raising the prospect of the first ‘earnings recession’ - two consecutive quarters of falling profits - in more than five years. Mounting troubles in the financial sector have led analysts to reduce sharply their forecasts for earnings growth in the final quarter of the year. In the past month, fourth quarter earnings expectations for companies in the S&P 500 have fallen by nearly half, according to Thomson Financial. Wall Street now expects earnings in the fourth quarter to increase 6.1% over a year earlier…”

November 9 – Financial Times (Deborah Brewster): “Shares in Sotheby’s, the art auction house, dropped more than 28% in heavy trading yesterday after a disappointing sale of Impressionist and Modern art in New York… The sale, the second big auction of a two-week season, brought in $270m, about a third lower than estimated, with a quarter of the works failing to sell. Some dealers pointed to the flat sale as evidence that the boom in art prices was coming to an end. There were also concerns over the level of price guarantees that Sotheby's has offered to -sellers.”

November 6 – The Wall Street Journal (John J. Fialka): “As fuel prices surge to new records, lawmakers are trying to limit a potential crisis that could leave many of the Northeast’s poor without adequate heating this winter. Last winter, 1.5 million low-income families in the region received assistance to help pay their heating bills. That number is expected to surge this year… Some smaller oil dealers who have sold heating oil under fixed-price contracts could face bankruptcy. Dealers generally try to carry their customers through the winter even when bills go unpaid, but companies that can’t procure enough oil could be compelled to cut off supply.”

Central Banker Watch:

November 7 – Bloomberg (Victoria Batchelor and Gemma Daley): “Australia’s central bank raised its interest rate to an 11-year high and sparked speculation of another increase after Governor Glenn Stevens said inflation will exceed his target. The nation’s currency surged to the highest in more than 23 years after the Reserve Bank boosted its benchmark rate a quarter-point to 6.75%...”

GSE Watch:

November 7 – Bloomberg (Karen Freifeld, James Tyson and Sharon L. Crenson): “New York Attorney General Andrew Cuomo subpoenaed Fannie Mae and Freddie Mac as he expanded his investigation into ‘widespread’ collusion between real estate appraisers and lenders including Washington Mutual Inc. Cuomo is seeking information on whether home loans purchased by Fannie Mae and Freddie Mac… were based on tainted property appraisals. Investment banks were also subpoenaed, he said, declining to name them. The attorney general's investigation calls into question the value of securities Fannie Mae and Freddie Mac have guaranteed from mortgages provided by lenders. Cuomo said he discovered a ‘pattern of collusion’ between lenders and appraisers and that he’s targeting banks beyond Seattle-based Washington Mutual for potentially pressuring appraisers.”

November 9 – The Wall Street Journal (Damian Paletta): “Federal Reserve Chairman Ben Bernanke yesterday floated a new idea to fix the troubled market for mortgages too large for Fannie Mae and Freddie Mac to buy: Allow the companies to securitize jumbo-size mortgages but have the federal government guarantee them. Fannie and Freddie currently can buy mortgages only up to $417,000, and Congress -- so far – hasn’t acted to lift that limit despite distress in that market that has made jumbo mortgages at "somewhat tighter terms and higher prices,’ as Mr. Bernanke put it. As an alternative to lifting that $417,000 cap, Mr. Bernanke offered a surprise answer to questions on Capitol Hill. He suggested that Congress could consider allowing the companies…buy mortgages of as much as $1 million from lenders, pay the government a fee for guaranteeing them and then turn them into securities to be sold to investors. ‘That would be, I think, of some assistance to the mortgage market,’ the Fed chairman said. "From the federal government's point of view, it would be taking on some credit risk, which you may or may not be willing to do.’ He added, ‘It would be a good idea to make the GSEs ultimately responsible for some, any excess losses, or some part of excess losses, relative to the premiums that are paid’”

MBS/ABS/CDO/CP/Money Funds and Derivatives Watch:

November 7 – Bloomberg (Neil Unmack): “Sales of collateralized debt obligations, once Wall Street’s fastest growing business, slumped to the lowest since January 2006 last month, Morgan Stanley said in a report. Banks and asset managers sold 18 CDOs totaling $12.7 billion, down from $16 billion in September…”

November 7 – Bloomberg (John Glover): “Fitch Ratings won’t publish new rankings for collateralized debt obligations until it completes a review of the way it grades the securities… Fitch is reviewing whether the assumptions it uses for rating CDOs accurately reflect the chances of default. Fitch will complete ratings on new transactions over the coming week. ‘Fitch is reassessing its analytic views which could impact existing ratings,’ Fitch…said…”

November 7 – Bloomberg (John Rega): “Emanuele Ravano, co-head of European strategy for Pacific Investment Management Co., comments on the credit-market crisis: ‘You will see an acceleration in the pace of asset-backed defaults and troubles.’ This is because the contagion spreads through linked investments, such as CDOs holding asset-backed securities. ‘When the structures start to fold, it accelerates very quickly.’ Banks will be forced to change business models, he said. ‘If people cannot securitize their loans, they will lend less’…”

November 6 – Fitch: “U.S. structured finance sectors that have so far been immune to the subprime market troubles may show signs of vulnerability due to rising uncertainty about credit conditions, along with income and employment prospects, according to Fitch Ratings in its latest Credit Action Report. ‘Economic growth was strong during the third quarter in spite of housing and credit market weakness, but tighter credit conditions will likely put a damper on consumer spending and lead to a deteriorating labor market outlook,’ said Director Kevin D’Albert. ‘Additionally, increased uncertainty about income and employment prospects may put a crimp in consumer spending, which in turn may adversely affect various consumer ABS segments.’”

Mortgage Finance Bust Watch:

November 6 – Bloomberg (David Mildenberg): “IndyMac Bancorp Inc., the second-largest independent U.S. mortgage lender, reported a loss five times bigger than the company forecast in September as foreclosures and late payments rose to a record…”

November 9 – Bloomberg (Adrian Cox and David Mildenberg): “Wachovia Corp., the second-largest regional bank, said mortgage-related losses total $1.7 billion so far this quarter… The company’s $1.3 billion of writedowns in the third quarter prompted its first earnings decline in six years.”

Real Estate Bubbles Watch:

November 9 – The New York Times (Floyd Norris): “The housing market is horrible in most parts of the country, says the chief executive of the luxury home builder Toll Brothers… Robert I. Toll, the chief executive, handed out grades for 37 markets that the company operates in, and most got a mark of F or worse. ‘The fact that I differentiate between F, F-minus and F-minus-minus’ shows just how bad things are… He said those grades ‘go from miserable to outright purgatory.’ The lowest grade went to Las Vegas and Tampa, Fla… The F-minus grade went to the vacation communities of Hilton Head, S.C.; Palm Springs, Calif.; the Maryland shore; and the Poconos area of Pennsylvania, as well as to Michigan and Atlanta. The F grade was the one most often given, going to Arizona, Massachusetts, Rhode Island, Minnesota and Southern California outside of Palm Springs. The cities of Chicago; San Antonio; Charlotte, N.C.; and Reno, Nev., got the same mark, as did the eastern and northern parts of Florida. Mr. Toll noted that Minnesota had improved to get its grade up to an F… Raleigh, N.C., fell to D-plus, while D’s were given to most of New Jersey and to Northern California, as well as to Washington and its Maryland suburbs, and the Philadelphia suburbs. D-minus was the grade for West Virginia and central Florida, including Orlando. Mr. Toll said the downturn was worse than the one in the early 1990s, adding ‘the growth in the rate of cancellations, the decline in new contracts, and the weaknesses we observed in October suggest that we still have tough times ahead.’”

November 5 – Bloomberg (Brian Louis): “The U.S. housing market isn’t recovering and could take years to rebound, Centex Corp. Chief Executive Officer Timothy Eller said. ‘This housing correction is already the deepest and it’s likely to be the longest,’ Eller said… ‘This is going to be the most serious housing correction in modern times and how far into it are we, I don’t really know. I just know that the correction will still take years to work itself out.’”

November 7 – Bloomberg (Daniel Taub): “U.S. office rents increased an average of 13% to a record in the third quarter, as vacancies in the nation’s downtowns stayed close to the lowest level in six years, real estate broker Cushman & Wakefield said.”

Crude Liquidity Watch:

November 7 – Bloomberg (Matthew Brown): “Saudi Arabia’s inflation rate rose to its highest in at least five years in September, an official at the Saudi Arabian Monetary Agency said. Inflation accelerated to 4.9% from 4.4% in August… Saudi food prices increased 7.2% in September while rents rose 11%...”

Fannie in Her Own Words:

The following paragraphs were extracted from Fannie Mae’s third-quarter 10-Q filing, issued this morning:

“We generate revenue by absorbing the credit risk of mortgage loans and mortgage-related securities backing our Fannie Mae MBS in exchange for a guaranty fee. We primarily issue single-class and multi-class Fannie Mae MBS and guarantee to the respective MBS trusts that we will supplement amounts received by the MBS trust as required to permit timely payment of principal and interest on the related Fannie Mae MBS, irrespective of the cash flows received from borrowers. We also provide credit enhancements on taxable or tax-exempt mortgage revenue bonds issued by state and local governmental entities to finance multifamily housing for low- and moderate-income families. Additionally, we issue long-term standby commitments that require us to purchase loans from lenders if the loans meet certain delinquency criteria...”

“Like other participants in the U.S. residential mortgage market, we have experienced and expect to continue to experience adverse effects from this market correction, which are reflected in our financial results. These include: Our credit losses and credit-related expenses have increased significantly due to national home price declines and economic weakness in some regional markets. Our ‘Losses on certain guaranty contracts’ have increased significantly… Because of the significant disruption in the housing and mortgage markets during the third quarter of 2007, the indicative market prices we obtained from third parties in connection with our purchases of delinquent loans from our MBS trusts have decreased significantly. This has caused us to reduce our estimates of the fair value of these loans, resulting in a significant increase in our initial recorded losses from these purchases…”

“Our credit-related expenses consist of our provision for credit losses and our foreclosed property expense. Our credit-related expenses increased to $1.2 billion for the third quarter of 2007, from $197 million for the third quarter of 2006. Credit-related expenses increased to $2.0 billion for the first nine months of 2007, from $457 million for the first nine months of 2006. Following is a discussion of changes in the components of our credit-related expenses for each comparable period. The provision for credit losses increased by $942 million, or 650%, to $1.1 billion for the third quarter of 2007, from $145 million for the third quarter of 2006. The provision for credit losses increased by $1.4 billion, or 381%, to $1.8 billion for the first nine months of 2007, from $368 million for the first nine months of 2006.

Approximately $670 million and $805 million of the provision for credit losses for the three and nine months ended September 30, 2007, respectively, relates to charge-offs recorded when we purchase delinquent loans from MBS trusts and the purchase price…exceeds the fair value at the purchase date… Accordingly, $633 million and $652 million of the increase in the provision for credit losses for the three and nine months ended September 30, 2007, respectively, was attributable primarily to a substantial decrease in the market value of delinquent loans we purchased from MBS trusts. The decrease began in July 2007 as housing and credit market conditions deteriorated, causing increased credit spread requirements and decreased liquidity for this type of asset…”

We are required by our MBS trust agreement to purchase loans from an MBS trust when specified predetermined triggers are met. Accordingly, we would expect to continue to incur these charges as part of our provision for credit losses in our consolidated financial statements. We do not expect the market prices for these delinquent loans to improve in the reasonably foreseeable future. The remaining increase in our provision for credit losses of $309 million and $750 million for the three and nine months ended September 30, 2007, respectively, is attributable to an increase in net charge-offs and incremental additions to the allowance for loan losses and reserve for guaranty losses during each period. The increase in net charge-offs in each period reflects higher default rates and an increase in the average amount of loss per loan, or charge-off severity…”

The increase in charge-off severity is attributable to the combined effect of the national decline in home prices and the higher unpaid principal balances of loans going to foreclosure. Foreclosed property expense increased by $61 million, or 117%, to $113 million for the third quarter of 2007… Foreclosed property expense increased by $180 million, or 202%, to $269 million for the first nine months of 2007… These increases were driven by an increase in the inventory of foreclosed properties and rapidly declining sales prices on foreclosed properties, particularly in the Midwest, which accounted for the majority of the increase in our foreclosed property expense in each period. The national decline in home prices has contributed to further increases in foreclosure activity.”

“Alt-A and Subprime Securities: We held approximately $106.2 billion in non-Fannie Mae structured mortgage-related securities in our investment portfolio as of September 30, 2007. Of this amount, $76.2 billion consisted of private-label mortgage-related securities backed by subprime or Alt-A mortgage loans…”

“To date, we generally have focused our purchases of private-label mortgage-related securities backed by subprime or Alt-A loans on the highest-rated tranches of these securities available at the time of acquisition… In 2007, we began to acquire a limited amount of subprime-backed private-label mortgage-related securities of investment grades below AAA. As of September 30, 2007, approximately $441 million in unpaid principal balance… We have not recorded any impairment of the securities classified as available-for-sale, as they continue to be rated investment grade and we have the intent and ability to hold these securities until the earlier of recovery of the unrealized amounts or maturity.”

“The increase in our single-family serious delinquency rate…was due to continued economic weakness in the Midwest, particularly in Ohio, Michigan and Indiana, and to the continued housing market downturn and decline in home prices throughout much of the country. We have experienced increases in serious delinquency rates across our conventional single-family mortgage credit book, including in higher risk loan categories, such as subprime loans, Alt-A loans, adjustable-rate loans, interest-only loans, loans made for the purchase of investment properties, negative-amortizing loans, loans to borrowers with lower credit scores and loans with high loan-to-value ratios. We have seen particularly rapid increases in serious delinquency rates in some higher risk loan categories, such as Alt-A loans, interest-only loans, loans with subordinate financing and loans made for the purchase of condominiums. Many of these higher risk loans were originated in 2006 and the first half of 2007. We have also experienced a significant increase in delinquency rates in loans originated in California, Florida, Nevada and Arizona. These states had previously experienced very rapid home price appreciation and are now experiencing home price declines. The conventional single-family serious delinquency rates for California and Florida, which represent the two largest states in our single-family mortgage credit book of business in terms of unpaid principal balance, climbed to 0.30% and 0.99%, respectively, as of September 30, 2007, from 0.11% and 0.37%... We expect the housing market to continue to deteriorate and home prices to continue to decline in these states and on a national basis. Accordingly, we expect our single-family serious delinquency rate to continue to increase for the remainder of 2007 and in 2008...”

“Mortgage Insurers: As of September 30, 2007, we were the beneficiary of primary mortgage insurance coverage on $329.0 billion of single-family loans in our portfolio or underlying Fannie Mae MBS, which represented approximately 14% of our single-family mortgage credit book of business, compared with $272.1 billion, or approximately 12%, of our single-family mortgage credit book of business as of December 31, 2006. In addition, as of September 30, 2007, we were the beneficiary of pool mortgage insurance coverage on $128.3 billion of single-family loans, including conventional and government loans, in our portfolio or underlying Fannie Mae MBS, compared with $106.6 billion as of December 31, 2006.

Two of our seven primary mortgage insurers have recently had their external ratings for claims paying ability or insurer financial strength downgraded by Fitch from AA to AA-… As of September 30, 2007, these two mortgage insurers provided primary and pool mortgage insurance coverage on $59.1 billion and $27.8 billion, respectively… Ratings downgrades imply an increased risk that these mortgage insurers will fail to fulfill their obligations to reimburse us for claims under insurance policies. We continue to closely monitor our exposure to our mortgage insurer counterparties…”

“Recent Events Relating to Lender Customers and Mortgage Servicers: Mortgage and credit market conditions deteriorated rapidly in the third quarter of 2007. Factors negatively affecting the mortgage and credit markets in recent months include significant volatility, lower levels of liquidity, wider credit spreads, rating agency downgrades and significantly higher levels of mortgage foreclosures and delinquencies, particularly with respect to subprime mortgage loans. These challenging market conditions have adversely affected, and are expected to continue to adversely affect, the liquidity and financial condition of a number of our lender customers and mortgage servicers. Several of our lender customers and servicers have experienced ratings downgrades and liquidity constraints, including Countrywide Financial Corporation and its affiliates, our largest lender customer and servicer. The weakened financial condition and liquidity position of some of our lender customers and mortgage servicers may negatively affect their ability to perform their obligations to us and the quality of the services that they provide to us. In addition, our arrangements with our lender customers and mortgage servicers could result in significant exposure to us if any one of our significant lender customers were to default or experience a serious liquidity event. The failure of any of our primary lender customers or mortgage servicers to meet their obligations to us could have a material adverse effect on our results of operations and financial condition…”

“Derivatives Activity: The primary tool we use to manage the interest rate risk implicit in our mortgage assets is the variety of debt instruments we issue. We supplement our issuance of debt with derivative instruments, which are an integral part of our strategy in managing interest rate risk… The outstanding notional balance of our risk management derivatives increased by $69.0 billion during the first nine months of 2007, to $814.4 billion as of September 30, 2007…”

Company management put a brave face on their predicament throughout this afternoon’s analyst conference call. They’ve been through tough housing downturns before, they comforted the analyst community. Although increasing Credit losses are an obvious concern, the management team is excited by opportunities presented by the difficult current environment. They assured everyone that they have a plan. More likely, they’ve been caught flat-footed by the nature of the unfolding Credit crisis.

I would imagine that only during the past couple of weeks has management begun to recognize the looming disaster confronting the GSEs. Sure, Fannie Mae has struggled (at times unsuccessfully) through past downturns. But never has a financial institution entered a historic housing bust with a “Book of Business” of mortgages, MBS and other Credit guarantees of $2.716 TN. This massive Credit exposure is backed by a $39.9bn sliver of Shareholder’s Equity.

The GSEs are the Kings of “structured finance.” On its $840bn balance sheet, Fannie holds $106bn of “private-label” MBS, the majority subprime and Alt-A. “Advances to Lenders” almost doubled in nine months to about $11.7bn. And they are today the “beneficiary” on $457bn of mortgage insurance. Responding to a question regarding the viability of the mortgage insurance industry they so depend, management stated that their internal analysis gave them confidence that the mortgage insurers had ample capital to survive the cycle. We and the marketplace have serious doubts. In their management of huge interest-rate risk, they have accumulated notional derivative positions to the tune of $814bn. Whether it is an unexpected (systemic) surge in Credit losses or major move in rates, the GSEs have grown too large for their derivatives to protect them. A devastating housing bust will bankrupt the mortgage insurers, while the solvency of their derivatives counterparties going forward will be in doubt in any number of scenarios. The GSEs are now integrally linked to what I expect to be Credit insurance’s and "structured finance's" astonishing downfall.

Fannie Mae lost $1.39bn during the third quarter. The company marked down its derivative hedging position by $2.24bn, although this loss was supposedly offset by the rising value of its assets (chiefly mortgages) in a lower rate environment. More disconcerting was the rapid surge in Credit costs. “Charge-offs, net of recoveries” jumped to $838 million during Q3, up eight-fold from the year ago $104 million. Fannie acquired 34,955 properties through foreclosure during the first nine months of the year, up 34% y-o-y. The “carrying value” of foreclosed properties during the nine months jumped 53% y-o-y to $2.913bn. And while the Midwest has the highest serious delinquency rate (1.14%), it is worth noting that the West showed the most rapid deterioration over the past year (doubling to .33%). This region also posted the fastest growth in foreclosed properties during Q3. The West accounts for 23% of Fannie’s exposure, and I’ll stick with my forecast that California and the West Coast will bankrupt the GSEs.

CEO Daniel Mudd addressed deteriorating Credit conditions during the conference call: “We previously said that our credit loss ratio would be in the range of 4 to 6 basis points this year. That is still what we expect. Going forward, projecting a 4% national decline in home prices and a scenario where there is not a nationwide recession, we can see our credit loss ratio move into the range of 8 to 10 basis points next year.”

A “scenario where there is not a nationwide recession?” Well, steeper home prices declines and a deep recession appear at this point a much more probable scenario. Quarterly Credit cost can be expected to grow to the multi-billions. Not surprisingly, Fannie is responding to deteriorating lending conditions as many typically do: Expand new business aggressively to offset mounting Credit losses and bet the ranch on growing your way out of trouble. In the face of rapidly escalating Credit problems and myriad market risks, Fannie expanded its “Book of Business” $98bn during the third quarter. Fannie’s “Book” inflated $243bn during the first nine months of the year, as Shareholders’ Equity declined $1.6bn. It is as well worth noting that Fannie's and Freddie's combined "Books of Business" had expanded at a 13.2% rate y-t-d ($430bn) through September to $4.78 TN, with a y-o-y rise of $516bn (12.1%).

Spreads (to Treasuries) on GSE debt and their MBS widened markedly this week. These perceived safe and liquid “money-like” debt instruments have for some time been an instrument of choice for highly leveraged speculation. I have no idea to what extent these instruments have been part of the infamous “yen carry” trade. But I do know that the yen rallied strongly this week, further pressuring the leveraged players and significantly exacerbating the unfolding Credit Crisis. And the beloved technology stocks - the favored long equities trade of the leveraged speculating community - were hammered. Meanwhile, the CDO market came under further stress and even the “emerging” debt markets reversed course. It is difficult for me to believe that the “sophisticated money” will not now attempt to be the first ones out of the hedge fund Bubble. Meanwhile, a backbreaking Credit Crunch is about to strangle the U.S. Bubble economy. “Structured finance” is a bust, while the major banks now recognize that this much more than a fleeting liquidity crisis. To survive, they will move aggressively to get their risk under control. If there were a more ominous scenario than the one developing, I’ve not thought of it.