Finance
Are we there yet?
Everyone wants to know.... have we found a bottom yet in the stock market? Last October we wrote that a break of the 7400-7500 on DJIA would be critical and should see a move towards 5800. The past few sessions have seen the market bouncing around the 6500/6600 level so we are certainly close, if not quite at 5800. On the economic front, it seems to us that there really isn't a lot more to shock to the downside - the market expects unemployment to continue to rise and sees no immediate turnaround in GDP either in the US or abroad. The failure to see another dramatic sell off after the payroll report last Friday shows the market has reached some degree of equilibrium.But there are still other events which can drag the averages down. There is some justified fear of another round of credit crunch, perhaps from problems in the commercial real estate market, perhaps from insurance companies selling bonds which have been downgraded. Perhaps both. However, what we see as the big cloud over the stock market and corporate earnings is pension plans. The market went through a scare not too many years ago about underfunded pension plans and the effect they would have on corporate earnings. For awhile the market suffered but an improved economy brought sunnier thoughts. Should the market once again focus on the need for many companies to add funds to their pension plans at a time when capital is scarce it would not be at all surprising to see the DJIA on a 5,000 handle, if not testing 5,000. This go around there does not seem to be an economic corner to be quickly turned to allow the accountants to say 'never mind!'
This is not to say the accountants still can't play around with the numbers. They most certainly can as the pension rules are convoluted - firms can take averages over many years, have 'contribution holidays' and muck about with discount rates. This may buy time in the short run but if the stock markets do not make a dramatic turnaround the clock will run out and those firms with underfunded plans will be in quite a bit of trouble. Merril has been on top of pension obligations and they are estimating over $35B in pension expenses for 2009 - figured when the averages were considerably higher. What is worse is that if there is a shift out of stocks and into bonds, the capital shift could be in excess of $200B. More frightening still is most of these plans have assumed returns in excess of 8% a year yet government bonds are at record low yields (for now), well below that 8% bogey. And a certain portion of their equity assets are not just paper loses but instead are never to return - AIG, GM, BS, LEH, etc.
But that is just a small tidbit of the pension nightmare. This time, Wall Street may actually pay attention to the underfunded plans of states and local municipalities. Now we are talking some real dough! As an example - the principal retirement funds for New York State have fallen over 50% (no surprise) - $60 billion. While a decade of stock market 'growth' has been erased, has a decade of pension obligations? What of California, a third world basket case of a state which can't seem to keep its regular budget short falls from exceeding the GDP of many small nations. How will it meet its generous public employee pension obligations?
The good news? Well the total capitalization of the US stock market is roughly $7.9 trillion per the Wilshire 5000 index. So there is still money to be found by selling stocks for those who need to raise cash. The bad news? The market cap has dropped by over $10 trillion since the fall of 2007. No wonder everyone is feeling so poor!
Are You Stimulated Yet?
We left the below comment on another blog in response to a post on the stimulation our government plans for us:Well if they count everything we will be approaching a 4, yes FOUR, trillion dollar federal budget. The first $1T budget was in 1987. $2T came in 2002. $3T came in, your choice 2006,07,08 as much of the war spending was not 'on budget'. Tack on $900 B and we are at $4T. Note that 30 years ago, in 1979 the budget was about $500B.
This year federal spending will be close to 28% of GDP. The prior, non-WWII peak was 23.5% in 1983. And to put these in perspective, in 1930, Federal spending was 3.4% of GDP, in 1950 15.6%. Is the problem really that the government is now spending too little?
There are two problems at the moment. Unsustainable spending on entitlements and the prevailing need "to do something". We all know about the first. The second though is left in the dustbowl of history - FDR (and Hoover before him). Contrary to popular belief, the massive post 1929 crash / depression time spending did little to change the picture. They were also suffering from the 'we have to do something' problem. While there was an initial rebound in the economy in 1934-36, things tanked again in 37 and 38 with unemployment going back to 1934 levels. Spending however increased 6% in 1930, 8% in 31, 20% in 32, 42% in 34 and 28% in 1936. There is no clear link between the massive increases in spending and resultant changes in gdp and employment.
[UPDATE 2/4/09:From the wires this morning, the Treasury Dept. said it will need to borrow $493 billion during the current January-March quarter, a record amount for this period, following actual borrowing of $569 billion in the October-December period, the all-time record.]
A bit rough and dirty, but the basic points are there. Very large spending programs by the government in dire economic times have historically not had the effect their proponents claim they would have. At best the New Deal spending is a mixed bag and some might argue the 1937 tank was in part a result of knock on effects from the massive stimuli. The current economy has already seen a huge stimulus - a few hundred billion directly to taxpayers under Bush and about $500B in aid to the financial industry. Interest rates are near 0, though that may apply more to the return investors are getting rather than the rate borrowers pay, assuming they are able to secure the financing they desire. We have long maintained that the ZIR policy followed by Japan in the 1990s through today has hurt and prolonged their economic slowdown and we feel the same will be true of the Fed version. We also believe that the end effects of the government running the printing presses at full speed will be inflation (not deflation) and eventually new bubbles. Are there any doctors in high places in our government? Primum non nocere!
We do not, however, summarily dismiss all government spending nor all the new spending proposed by the new Administration. Our highways require significant maintenance as do our many state controlled roadways and bridges. If well monitored, spending in this area will be worthwhile, but is not likely to provide any short term stimulation to the economy. Increased funding to our national labs, in particular to the physical sciences and technologies, will ultimately pay significant dividends both to the economy and our knowledge... just down the road a bit. But these are things which should be addressed in normal, continuing resolutions and not emergency spending bills. These are investments, not stimulus.
Our current spending is unsustainable. At some point our creditors will pull the plug and/or our currency will devalue significantly. The government is on track to become an ever larger percentage of the economy and we all know that the government does very little well. The entitlement bogey man must be addressed, the sooner the better. However, if our politicians feel they absolutely must, must do something now! we recommend significant tax credits for the formation of new (not realigned) businesses. Giving people an incentive to start a business and hire employees is a far better way to go.
Retail Sales & Payrolls: Don't Panic!
The headlines sure are shocking this morning! Retail sales plunge again in November! Down 1.8% from October and 7.4% from November 2007 !!! The sky is falling, details at 11pm! Unemployment claims surge again!Well stop and take a deep breath. Now we are not going to tell you things are peachy for the economy but we will try to bring some sanity to the headline numbers. Lets start with the retail sales figure as here we use the figures from the release. On a seasonaly adjusted basis (we aren't fond of these but its the only way to compare month on month):
US Retail Sales as Reported 12/12/08
| ItemNov 08 | Oct 08 | Nov 07 | |
|---|---|---|---|
| Total Sales | $355,655 | $362,035 | 384,099 |
| less Gas Stations | $32,653 | $38,274 | $41,875 |
| Net | $323,002 | $323,761 | $342,224 |
| Change | -0.23% | -5.62% | |
| less Autos | $51,637 | $53,736 | $71,461 |
| Net | $271,365 | $270,025 | $270,763 |
| Change | +0.50% | +0.22% |
Wait! You mean.. taking out gas station sales leaves November nearly flat compared to October? Who would have thought plunging gas prices might overstate the decline? And.. oh no.. this can't possibly be! Ex-gas stations and Ex-Autos... retail sales were actually up not just on the month but the year? Shocking! Of course lost sales in the auto industry is not good either, but by excluding them we see the rest of the economy is flat but not off a cliff. (This should be a lesson too on the upside - things were never quite as great as made out.)
As to the non-farm payroll and weekly claims reports - two points come to mind. First, there had been a large disconnect between the job losses over the past year as reported by the household survey (used for the unemployment rate) and the non-farm, corporate supplied data - roughly 2 million jobs. We suspect much of the recent drops (including revisions) to the more official non-farms data reflect a catching up and ties in with the recent increases in claims, our second point. Its our opinion that much of the recent jump in claims and the non-farm are because both (former) employees and employers were not yet able to file for unemployment insurance or report jobs as lost until severance payments had run out. Thus we think much of this large bump relates to the many cuts announced last spring and summer and is not necessarily an acceleration in the present time frame. Others announced layoff plans this fall and those may still be in the data pipeline, so the headline numbers are likely to grow but we may be closer to the end than the beginning of the major layoffs.
Its Official: Stocks Worse than 73-74
This was quite a day in the financial markets. US Treasury bond yields hitting record lows and prices rising at a record pace. First time claims at a 16 year high. Another late day swoon in the equity markets. And swoon they have. It can now be said officially: The bear market of 2007-2008 is worse than that seen in 1973-1974. During that very unmemorable period, the S&P 500 index declined from a peak of 121.74 in January, 1973 to a low of 60.96 in late September, 1974 - a decline of 49.93% over 21 months. It then rose about 50% off the lows during the following 9 months and by early 1976 was trading only about 15% below its 1973 peak ... for the next 18 months. All told, the index traded over 4 years in a range of -25% to 0 compared to its peak before finally making a new high in July 1980. The chart below shows that period.
The bear market of 2007-2008 (lets hope it doesn't continue into 2009!) has now seen a drop of 51.9% in the S&P 500 index over a 13 month period - greater and faster than 73-74 and rivaled only by the 1929 crash (in the US). Graphically:
Finally, the view from 1965 thru late 2008:
As a bonus for those of you into BDSM, here is a view of the DJIA from 1928 until 1965. It took over 25 years to regain the 1929 high with over 15 years spent at under 50%.
CDS Insanity
Lest you be lulled to sleep by the daily 400+ point swings in the DJIA, word comes yesterday of new insanity in the capital markets. Bloomberg is reporting that Credit Suisse and Citi are now using credit default swap rates to determine rates on corporate loans. Yes, there were reports of unidentified pigs flying over NYC last night. So now future loan agreements will have rates decided not as a spread to LIBOR based on a firms credit rating and a thorough analysis of its balance sheet by bank loan officers but on the whims of an illiquid derivative market which is prone to bouts of extreme panic.How does this all work? Cited in the Bloomberg report is the case of FirstEnergy:
FirstEnergy, with utilities in Ohio, Pennsylvania and New Jersey, agreed this month to link interest rates on a $300 million credit line to the cost of Libor as well as the sum of the spread on its default swaps and those of Credit Suisse, according to a regulatory filing. Loans from the Zurich-based bank would require total interest payments of about 6 percentage points over Libor if the power company draws on the bank line, according to regulatory filings and Bloomberg data. That's almost 14 times the spread on a $2.75 billion credit line the company negotiated in 2006.So not only is the rate dependent upon their own 'rating' in the CDS market, it is also dependent upon how the market views the default risk of Credit Suisse. What kind of nonsense is this? The borrower should pay more because the market thinks the lender more likely to default?
The utility would pay Libor plus 3 percentage points to draw on the line, according to company filings. Based on yesterday's levels, FirstEnergy would be charged an additional 1.70 percentage points, reflecting the levels of its credit- default swaps, and another 1.35 percent to account for the bank's own spread, according to Scilla. Pricing on the loan will change as Libor and the swap spreads on Credit Suisse or FirstEnergy move. Source: Bloomberg.com
The game here seems to be the banks wanting to appear to provide a credit facility, while in fact, offering nothing. As the only time most firms need these lines are in times of economic or market turmoil, CDS spreads are likely to have increased dramatically for both the borrower and lender. As an example of the former, consider what happened to many insurance companies at the beginning of October. Not only did the CDS rates for Hartford, Metlife and Lincoln National blow up to 500 bp, they went to trading on an upfront basis requiring prepayment of from 500 to 1100 bp. Those rates are now down dramatically, though still at elevated levels of 300-400 bp. "Normal" might be measured in the 10s of basis points. Would any of these companies have been able to draw on these lines at the start of October? This realization has led a number of companies, such as Nestle, to demand caps be in place in exchange for accepting these new terms.
This move to using CDS as the basis for loan terms will also open another Pandora's box of speculation in CDS contracts. There is already a perception that CDS have been misused by speculators who were short equity to help force bankruptcies by driving up the cost of funding for a company to impossible levels. Having revolving loan agreements also tied to CDS will remove the last fire wall against this type of activity, perhaps even opening the door for another company to push a competitor under. It really is shocking that after the near meltdown of the capital markets this fall that we should move deeper into the unknown while the original fires are not yet out.
How Low Can It Go?
The sigh of relief which the world equity markets breathed earlier this week just became a gale force wind pushing prices back near last week's lows. Most technicians look at variants of bar charts or candle charts of various durations for guidance on market direction. Less so the point and figure chart and even rarer the percentage change point and figure chart. The beauty of pf charts are the clarity they bring by consolidating market movements. Below are a few charts we made at StockCharts.com tonight of both the Dow Jones Industrial Average as well as the S&P 500 index. Each box represents a move of 3 ⅓% and reversals occur when direction changes by three boxes (10%). The first two charts include the daily high and low to determine how many up (X) and down (O) boxes to draw. The latter charts use only the daily closing price and the change from day to day to calculate which, if any, boxes to draw.It looks to us that a break of DJIA 8100 again should see a test of 7500-7500 area (these days perhaps within hours). Looking at a longer dated chart, this is a very key level and provided support in 1997 and 1998. A break would open up significant more downside, with 5700-5800 looking to be the objective. Eeek! The serious break level in the S&P is about 790.
A Solution To The Credit Crisis
No matter which way you turn, somebody has serious problems with the Paulson 'bailout' plan as proposed and amended by the house and senate. Our own view is that the situation is too far gone to just let the chips fall where they may. But we also agree that the Paulson proposal has serious flaws and may not work at all. We would like to propose a far simpler plan which addresses the immediate problem while also attempting to protect the taxpayers.The Financial Gedanken Experiment
- Immediate elimination of mark to market accounting for those assets which were originally booked as 'hold to maturity'.
- Immediate formation of a Mortgage Trust to purchase, at historical cost, up to $1.5 trillion of mortgage securities and associated securitizations such as CDOs
- If purchases by the trust fund are oversubscribed, it shall fill orders uniformly based on the largest percentage of total assets which absorbs the fund and no single firm placing more than $100B until all others have had their entire request fulfilled.
- The Mortgage Trust will hold to maturity for the benefit of each institution the securities tendered.
- Each institution shall be responsible for any net loss, accounting for recoveries, on securities sold to the Mortgage Trust.
- Each institution will pay back any net loss amortized over a period of 20 years, payable in full at any time.
- Each institution participating in the program agrees they will not pay any dividend on common stock or new preferred shares until such a time as their account with the Mortgage Trust is cleared and any losses are repaid.
- Each institution agrees no top managers will be paid more than $500,000 in salary per year and any bonus shall be in equity with a value of no more than $1 million at the date of the award with 50% of any shares restricted until the account with the Mortgage Trust is cleared and fully settled.
- Each institution shall pledge its remaining assets against its obligation to the Mortgage Trust.
So what does this plan accomplish? First off, it recapitalizes the financial institutions by allowing them to book their non-impaired hold to maturity securities at historic cost as was done pre-Enron. Second, it allows them to remove from their books impaired securities or those which are not yet impaired but likely to be in the near future. But it is not a free ride. Unlike the Paulson plan(s), the taxpayer is not on the hook for the losses. Instead, each firm participating will be required to make good on the net losses over a 20 year period. By allowing a lengthy period, the government enables the firms to continue their normal operations without a gun to their head of a single large payment due in a short time. However, to accelerate the process, no dividends will be paid to shareholders thus preserving cash which can be used to pay off these debts. Likewise, the mega bonuses of the past will be eliminated. It would be in the institutions best interest to clear these obligations as soon as they are financially able so as to once again pay their shareholders dividends as well as have more flexibility with executive compensation. As a backstop, the government will have first claim on the assets of any firm unable to meet its obligation to pay the ultimate losses on the securities sold to the Mortgage Trust.
This, to our thinking, is a far better way to proceed. It frees up significant capital immediately, allows firms flexibility in whch assets to sell, allows firms to spread potential losses out over a long period of time if need be, allows the government to receive any income paid on the securities, puts the firms on the hook for any future losses, and places some constraints on the institutions to prevent 'rewarding' bad management. All these combined will allow firms to go back to normal operations (lending) and eliminate much of the counter party fear gripping the credit markets.
Beyond this initial proposal, which we see as the most pressing, we would enact a follow on which looks to some of the other problems. We wouldn't dally too long here either:
- Restore the uptick rule.
- Complete ban of naked shorting except by a market maker providing liquidity to facilitate an investor purchase.
- Institutions selling total return swaps are not exempt from the uptick or naked shorting restrictions.
- No shorting of any stock with a price under $15.
- A complete investigation and review of the credit ratings agencies.
What remains is the issue of credit default swaps. This is a bit more tricky. The most significant problem with CDS are counter party capitalization and pure speculation. As CDS are at their heart insurance, institutions selling these contracts should be regulated in a manner similar to existing insurance operations. This would prevent a holding company taking excessive risk underwriting CDS contracts without commensurate capital in place. Likewise, it would also prevent hedge funds from being a writer of CDS as few, if any, have sufficient capital to make good on any contract which is exercised.
Speculation in CDS must also be addressed. The current notional outstanding far exceeds the debt they are written against. Simply put, too many people have an economic interest in seeing companies fail and thus default on their debt obligations. Going forward, restrictions can be put in place which required the buyer of CDS to own the underlying security and in the same amount. That, however, does not eliminate the looming present day problem. With no better solution at hand, we are inclined to suggest the nullification of all contracts where the purchaser does not own the underlying. Contracts would be settled at original cost with all periodic and up front payments returned to the buyers, with interest. This is preferable to allowing the sellers of the CDS contracts the opportunity to cherry pick those contracts they wish to negate. It is hardly a beautiful solution but we see no other practical way of eliminating this very large ticking time bomb.
Paulson's Fantasy
Those in the world of finance have seen things happen in the past 10 days which they never could have imagined. The Fed/Treasury pulling the plug on Lehman Brothers, before the market did so, an extortionist 'bail out' of AIG, money funds breaking a buck, 20-50% moves in some financial stocks (over $10), and now to top it off, comes Paulson with his 'plan'.A few choice items from the Pauly Plan:
Authority to Purchase.--The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United StatesSo lets take a look at this. Paulson is going to 'designate' certain financial institutions - who were probably either a holder or seller of the various bad debts and derivatives - to act as his agent. We assume this shall be to buy, hold auctions and value these securities. And of course, pocket what will likely be some substantial fees.
Necessary Actions.--The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this Act, including, without limitation:
(3) designating financial institutions as financial agents of the Government, and they shall perform all such reasonable duties related to this Act as financial agents of the Government as may be required of them;
Sec. 5. Rights; Management; Sale of Mortgage-Related Assets:
(b) Management of Mortgage-Related Assets.--The Secretary shall have authority to manage mortgage-related assets purchased under this Act, including revenues and portfolio risks therefrom.
The Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time
Sec. 8. Review:
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.
For purposes of this section, the following definitions shall apply:
(1) Mortgage-Related Assets.--The term “mortgage-related assets” means residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before September 17, 2008.
Paulson will also manage the portfolio of assets the Treasury buys. We wonder though, where will the expertise come? Does the Treasury Dept. have on hand staff who are versed in RMBS, CMBS, CMOs, CDOs, CDO2, CPDOs? Or will Paulson fall back at his agents at Goldman Sachs or JP Morgan to value these assets? And wasn't that the root of the problem? And by the definition above, Paulson can buy all of those and probably a few other things nobody has heard of yet.
The press keeps bleating about this being a $700B bailout but in fact, it can be much larger. Paulson will be allowed to keep $700B at any one time on his books. So as some paper matures or is sold, he will be able to buy more distressed assets.
Perhaps the most offensive portion of the Paulson proposal is his coronation as Financial Emperor of the World. Nobody, not even the Spanish Inquisition, may ever challenge any decision he makes going forward with this plan.
But the most glaring error in this whole plan - what makes it a complete fantasy - is that he has no authority to force anyone to sell things they do not wish to sell. Will Paulson show bids sufficiently high to attract selling interest? After all, if a bank or other investor has been holding a CDO tranche they believe will be worth at least 40 cents (or perhaps much more), why would they hit Paulson's 10 cent bid when they chose not to hit the same already? And why, if a firm has already written down as unrealized loss or impaired 70,80 or 90% of an asset, would they sell it to Paulson and then lose any upside while turning an unrealized loss into a realized one?
The Paulson plan, just like all prior actions by the Fed, SEC and Treasury Department, is too little, too late, ill conceived and reactionary. As it stands now, it will have limited, if any, positive effect.
AIG - Q3 Expectations and Capital Needs
We've spent the past few days trying evaluate AIG's 2nd quarter report and use it as a basis for a guesstimate of what may be on tap for Q3. From our perspective there are four primary issues:(1)CDS portfolio valuationWe note up front that our modelling methods are very crude and at best ballpark approximations as we relied heavily on the Markit ABX-HE indices as well as AIG's conference call and 10-Q presentations. The ABX-HE indices are synthetic CDS based on a pool of 20 underlying CDOs of the same credit grade issued in the prior six months. In the case of the AAA ABX-HE tranche, it is well known to be one of, if not the lowest rated AAA (it is longest in duration of the AAA's). To address this short coming, Markit has added PENAAA tranches which are one step higher up.
(2)Investment portfolio valuation
(3)Liquidity Needs
(4)Dividend
AIG's CDS portfolio is (notionally) concentrated in the regulatory capital relief area which for all intents has been and should remain nearly risk free. The problems have been in the multi-sector area, particularly those swaps on CDOs with subprime or alt-a collateral. AIG stopped writing these multisector CDS in the first half of 2005 and much of the portfolio was written on 2004 and earlier collateral. Thus, using the ABX-HE-2006-H1 index is, at best, only a very rough approximation. There is also the question of subprime vs alt-a collateral, though that seems to be a matter more of degree of correlation. In addition, we have made assumptions that those credits which are on watch for downgrade will only be moved down one notch this quarter.
As a test, we modelled AIG's CDS losses from Q1 and found our estimate to be about 15% too high - again, not surprising as we are using an index weighted for 2005 H2 collateral against a portfolio written against 2004/2005H1 CDOs. Adjusting for this overshoot, we come up with these figures for Q3:
We estimate the current marks as of 8/18 are $1,300B
If current price trends continue but no collateral is downgraded, we estimate unrealized losses of $2,100B
If current price levels hold and all collateral currently on watch is downgraded, losses of $6,500B
If current price trends continue and all collateral currently on watch is downgraded, losses of $7,100B
For purposes of the CDS estimates, we assumed that the downgrades were distributed by grade as in the Conf Call Supplemental pg 10.
By 9/30, assuming the collateral on watch is all downgraded, fully 60% of AIG's CDS portfolio will have been marked to A credit or lower. From a valuation perspective, the underlying collateral has been written down to near nil. At this stage it becomes pointless to try to estimate Q4 marks as there will be little 2005 exposure left and we will be guessing what, if any, of the 2003/2004 swaps remain to be hit with no easy reference valuations.
Keep in mind, the above figures are all unrealized losses, or as AIG likes to call them, economic losses. AIG does modelling for this very complex task and have estimated ultimate realized losses of $5B to $8B. Their model and assumptions have come along way since 2007 and appear to be very conservative. For example, in coming to the $5-8B figure, they assume virtually all mortgages that become delinquent will be foreclosed.
Our best guess is that the CDS will suffer on the order of $5B in marks this quarter, similar to Q2 and less than our $6.5-7.1B worst case scenarios, primarily as we expect most, but not all, of the collateral on watch to be downgraded.
The investment portfolio is a similar beast but with most of the risk in 2006 and 2007H1 RMBS. Ironically, while one half of AIG was selling protection the other was going without. We have applied a similar methodology to the RMBS portion of the investment portfolio as we used for the CDS - the various ABX-HE indices. Again, at best those indices are ball park proxies for reality.
Based on downgrades through 7/31 and assuming 2/3 of the $6.1B on watch negative are downgraded one step with 90% AAA and 10% AA:The problem for both the investment portfolio and the CDS portfolio is not so much that the market values for any particular credit grade deteriorate but that collateral be downgarded. The drop from AAA to AA is a cliff, as is from AA to A on the older 2005 collateral. Once again though, these are only unrealized losses at this stage. In fact through July, only two tranches of the Markit indices have suffered any writedowns - 2006-BBB-H2 and 2007-BBB-H1 of about 5% in each. Realistically this will go up as homes go through the foreclosure process but considering the level of subordination in the RMBS portfolio we would only expect very small, if any losses in the Alt-A and subprime paper. The area we see as more likely to have a loss (though not large in absolute terms) would be the prime loan RMBS where subordination is only 2-3%.
Based on CMBS portfolio also showing same level of marks as Q2 of $400M
Based on Jumbo/Foreign MBS showing slightly worse than estimated Q2 marks of $1B
Based on HELOC and 2nd Lien already reflecting significant downgrades
We estimate (whether reflected as OTTI or unrealized loss) marks of $5,305B +/- 15% ($4,500-$6,100B)
But what of AIG's liquidity needs? This is currently the subject of much chatter in the market and it seems most of it from shorts. Since Q1, AIG has raised a total of $23.5B in new capital. But what have the used and what looms ahead?
AIG has posted collateral of $16.5B thru Q2 against CDS, up from $9.7B in Q1.
We expect this to rise in line with expected losses in the portfolio. Taking our 2nd worst case of $6.5B marks, expect collateral posted to climb to $23B. This would be a use of $13.3B
2a-7 puts. They have issued a total of $11.3B notional including $7.5B from a commitment made in 2005. Of this, they purchased $917M in Q2 and have taken loss reserves of $810M. The buyers of the puts have agreed to provide liquidity for up to $8.5B of which $3.2 is in use. No effect except the balance sheet enlargement.
CDS with over collateralization provisions resulting in accelerated payment: Roughly $8B notional in total of which $1.5 (6 securities) have had such defaults and $103M has been purchased at par (1 security). The majority of the $8B notional is not multisector w/subprime. Additional needs: $1.4B
Ratings Agency Downgrades. Would result in $14.5B additional collateral demands against the GIA's for a 2 notch downgrade ($13.3 for one notch, $10.5 if only by one agency). Prepayment risk of $4.6B - $5.4B on contracts subject to early termination but unlikely due to the forfeit of large economic benefits. Additional needs: $14.5B
Income from operations: $2.9B per quarter or $5.8B total which reduces need for capital.
AIG had cash from operations of $16.6B for 2008 H1
AIG has revolving credit lines, some with one year add-ons which total $9.2B
Adding that all up, AIG has already used or is expected to use about $23.4B of capital through Q3, including the potential of a ratings agency downgrade.This would leave them in the same position as the end of Q1. However, unlike Q1, the swap book has for all intents been kicked to the scrap heap. It -more-
The Scourge of Short Sellers
Citibank 15, AIG 20, Merrill Lynch 22, B of A 19, LNC 42, Freddie Mac 4, Lehman 13 ... the list of financial companies whose stock has been battered the past few months is seemingly endless. Most are down at least 50%, many over 70% from their 52 week highs. By now we all know the story behind the plummet - sub-prime CDOs, CDO2, CPDOs, CDS and the resulting very large write downs. Certainly, some degree of punishment was appropriate for these companies given the poor risk controls and for some, reduced earnings potential over the next few years due to de-leveraging. Some have also taken realized losses on their bad investments or non-performing loans. Yet many, especially the insurance companies, have only taken paper losses and will quite likely see write-ups over the next two to three years. This is because they are valuing many of their holdings at extremely low levels because of a lack of liquidity in the markets for these specialized assets. Simply, if nobody wishes to buy anymore of these assets the only bids (if any) will be below fair/intrinsic value. Anybody who has sold a home or auto in a stagnant market understands this - bids will be few and usually well below what anyone would consider 'fair' value yet unless you absolutely needed to sell you would wait for the market to improve. The same applies to many of the CDOs and CDS on the books today but unlike a house which remains yours until sold, these assets are continuously receiving income streams which shortens their expected life. So while nobody may want to buy your CDO or CDS, you may in fact be paid back all you were due (or not pay in the case of a swap).So why have their stock prices gone so low? Is it simply panic selling? We will concede a portion of the move to 'panic' selling by investors who have suffered margin calls, wish no more pain or no longer understand what they own and are willing to take their lumps immediately. But panic selling happens over a short period of time, not over weeks and months. The plummet from late last week through this past Tuesday smelled of panic selling but that explains only the last few points. What of the rest that could be deemed 'excessive?' To begin, one should probably look at the daily volume traded.
Since June 17, Citibank has traded 49% of its 5.2 billion share float. AIG about 46% of its free float. Freddie Mac 274% of its float. A typical trading day a year ago would see each of those companies trade 0.5% of its float, or 11% over a 22 day period. So without question, turnover is way up. As are the number of shares being sold short. Short sales are the sale of borrowed stock - perhaps you think company A will report bad earnings and you would like to profit on an expected move lower. You can ask your broker to 'borrow' shares from another account which you can then sell. When you close your short position by buying the stock back, those shares are returned to the original holder. Most times there is no asking involved, brokers as part of their normal operations will borrow shares of common names and typically provide traders with a 'short-list' detailing which stocks can be shorted and how many shares are available. If the name you want is not on the list, they can usually call around to find some shares to short but probably will not bother unless the amount is worth the trouble. Not surprisingly, brokers get a small fee for lending the shares (you didn't think the actual owner would, did you?) which may rise as demand for shortable shares grows.
Short selling has always been viewed negatively by many investors who rush to blame 'evil short sellers' every time their stock declines in price. This is, of course, a naive view. In the normal course of things, short sellers provide additional liquidity to a market thus enabling those seeking to buy to obtain shares at a better price. In thinner issues, a short seller could also be the difference between buying your amount at one price instead of paying increasingly higher offers for smaller pieces until your order is complete. And those investors who regularly blame short sellers for all their ills rarely, if ever, thank them for pushing prices higher when they cover en masse creating a 'short rally'.
There are also non-speculative, legitimate reasons for short selling used daily by hedge funds and portfolio managers. As an example, a fund might hold a long position in Chevron feeling it is well run and has good reserves. However, they may not have good feel for the direction of crude prices in the near to medium term. In addition, when deciding on the purchase of Chevron they reviewed Exxon Mobil but felt it was not replenishing reserves fast enough and that management was not proactive. This presents the fund manager a way to stay long Chevron while minimizing his exposure to uncertainty in the crude market - to sell short an equal value of Exxon Mobil. As long as he holds this position his return will be based on the relative performance of these two companies. There are also a large number of hedge funds which use a 'long-short' strategy as the underlying basis for the fund, seeking to be market neutral. Gains (or losses) are achieved through fund manager 'alpha' - the ability to add (subtract) return in excess of the market. But again, we are speaking of relative stock/sector performances. A long/short strategy can be successful even if those stocks sold short increase in value. -more-
Credit Crisis Accounting
You've probably read quite a bit of ink on how accounting rules have had a large effect on the size and timing of losses at many financial firms this year, in many cases forcing these same firms to raise new capital at generally unfavorable rates. In the past, most firms owning bonds or other financial instruments with the intent to hold a significant period of time, generally until maturity, have been able to 'value' these assets at their original historical cost - regardless of the current market price. However, the accountancy boards have recently shifted gears and deem this as no longer acceptable, in particular for impaired assets, and now suggest firms use mark to market valuation.On the face of it, mark to market valuation sounds like a reasonable approach to present fairly to investors and regulators the balance sheets of companies holding financial assets. Why should bonds bought at par but now trading at 90 be kept on the books at 100? What of certain asset backed and other more exotic securities which might now only be worth 10 or 20 cents to the dollar - according to available market prices? Conversely, if the intent is to hold to maturity, short of bankruptcy or default, the asset will return its full expected value, so why bother reporting gains and losses which will ultimately wash? And how does one accurately value securities which may have little or no secondary market trading? In some cases products are so specifically tailored for the buyer that there may be no other 'identical' security to look to for pricing guidance.
And these problems have acted as accelerant on the credit crisis. Dealers and other investors, fearing the worst, stopped bidding for CMOs and other hybrid securities which resulted in a price vacuum. Ultimately prices were quoted with extremely low bids while offers from sellers were significantly higher. Some were so low as to all but imply impending default. But what about those holding securities in inventory or investment accounts? What should they use to mark to market their holdings? The accountants say you must still use what ever market price is available, however unrealistic that price may be. The subsequent unrealized losses were huge - tens of billions of dollars in some cases and some firms felt pressed to raise more capital either for immediate liquidity needs or to satisfy regulators or rating agencies. This was a decidedly poor outcome of mark to market accounting and exposed to to be just as imperfect as historical cost basis when trying to value illiquid securities.
A battle is going on right now between those who wish to keep the mark to market method and those who wish to go back to the historical cost approach. Of course, there is posturing by those who benefit most from each method (either directly or through damage to a competitor). We would like to propose a better way which attempts to strike a balance between the two methods: amortizing the gains/losses from mark to market valuation over the expected holding period of the underlying assets. Should the securities be sold prior to this date, all remaining gain or loss must be realized immediately. Footnotes can be added to financial statements showing expected amortization schedules to provide investors a complete picture of the firms portfolio risk while avoiding the crash and burn of the current system. Losses would be more manageable as they are realized gradually over a period of time and the need to raise capital could be reduced or even eliminated. Also eliminated would be the negative feedback loop of firesales of portfolio holdings to raise cash and/or eliminate risk. Certainly this is a better approach than naive mark to market or historical cost accounting?
Inflation: Not Just Food And Energy
We've been pounding the table on the inflation picture for quite some time and the PPI data released this morning confirms - its not just about so called 'commodity' inflation anymore. The headline figure for April was +0.2% (SA) increase from March but the 'core' ex-food ex-energy was reported at +0.4%. This is for the category deemed 'finished' goods. Further down the chain, 'intermediate' goods (ex-food/energy) was +1.2% and 'crude' goods (again, ex-food/energy) were +7.9% ! Lets look at this data in a bit more detail, on a year on year basis so as to avoid the dreaded seasonal adjustments.Finished Goods: From April 2007, finished goods ex-food/energy rose 3.0%. However, consumer goods ex-f/e rose 3.6% and consumer non-durables ex-f/e rose a hefty 4.5%. Adding food and energy to the mix brings the annual change in finished consumer goods to an astounding 7.7%. Is it any wonder why the consumer feels pinched more and more every day?
Intermediate Goods: Year on year, ex-foods and energy, the middle state of production saw an increase of 5.8%.
Crude Goods: Here we see the largest increases. Crude energy materials rose 51.9% in the past year. Shocked? Well, ex-f/e, crude goods rose 24.6!.
The notion that there is no pricing power seems to have been invalidated in the past year. Clearly, firms have been able to raise prices through out the production chain. The bigger question is why this is not more accurately reflected in CPI. There are only three explanations: (1) Productivity rose faster than the price of inputs hence firms were able to hold the line on final pricing, (2) Firms were unable or unwilling to pass on price increases to the final consumer and instead saw margins reduced or (3) CPI is just wrong. Probably a combination of the last two choices; we tend to put the most weight on CPI being wrong.
Fed Monkeys
With few exceptions, the Federal Reserve governors have taken the persona of monkeys: speak no evil see no evil hear no evil. Of course the evil here is inflation. And the few who have been brave enough to even raise the topic in their public events are careful to say 'we must be vigilant!' and 'we see it coming down soon!'. We don't have access to LexisNexis to verify but it seems to us that has been the infrequently mentioned party line for over two years.Yesterday brought a shocking revelation (well, the latest installment): inflation is alive and well. The Labor Dept. released the March PPI (producer price index) data and it was a shocker - so much so that most of the 'major' media outlets picked up the story and fretted over the 1.1% headline increase in the cost of finished goods. The Fed crowd of course were quick to say 'food and energy!' and took solace in the 'core' reading of +0.2%. Lost on both groups?
Intermediate goods: +2.3%, core +1.1%Those are month on month changes, not annual.
Crude Goods: +8.0% core +3.5%
This morning saw March CPI up 0.3% while core posted a 0.2% gain, matching market expectations. Consumer prices rose 4% on a year-over-year basis, same as Feb. Core CPI grew 2.4% on an annual basis. Once again, there are those who are pointing to this release as indicating 'inflation is well contained'. Of note, 6 month treasury bills are yielding 1.45%, 2 year notes are 1.85% and 5 year 2.69%. Only 30 year paper trades over the annual inflation rate (based on y/y CPI) at 4.45%.
We ask: How long before the intermediate and crude components of PPI are passed through into CPI? Asked another way, for how long can companies absorb these increases in inputs (by productivity gains we are told) before their margins begin to erode and consequently, earnings?
It was nice to see that former Reaganite Martin Feldstein wrote yesterday in the WSJ that it was time for the Fed to stop cutting rates or risk further fueling commodity inflation while not helping (and probably hurting) the underlying US economy. We here at Rant Street have been saying this for a few years now but better late than never that someone with clout catches on.
UPS and Inventories Trump Citi
The US equity market has looked a little bit tired the past few days and it appears to be giving in to pressure from an earnings warning from shipper UPS as well as economic data on wholesale inventories. Positive news from Citibank - something one would expect to propel a market that has had nothing but 'credit crunch' on its brain for months has so far failed to stem the red prints.The UPS warning should not have been surprising at all in the light of a slowing economy and very high fuel prices. While noting a rise in shipments in January, business has turned down since with a notable decline in higher value shipping services. Perhaps the need for overnight is not so great, especially in the age of the internet (one also has to wonder the effects of the sagging mortgage industry on overnight/two-day packages).
Citibank is said to be close to a deal with private equity firms to take $12 billion of LBO debt off their books at about 90, roughly 30% of the LBO debt they are carrying. This is a positive not just for Citi who will reduce their cash needs but the market as a whole. We seem to have hit a point now where some people are willing to step up and actually buy paper in which they see value. Citi will take a p/l hit but that is a small price to pay to clean up their balance sheet. If/when this deal is finalized, it could open the floodgates as those with cash begin a rush to purchase before these 'values' are snatched up. Whether this will eventually spill over to the CMO market is a good question but any answer is probably at least three months down the road.
People seemed a bit put off by the February wholesale inventory report today, focusing only on the month/month change. On a seasonally adjusted basis Feb. saw sales fall 0.8% and inventories rise 1.1%. Yet looking at the year on year change, sales are up 12.2% while inventories have risen only 7.4% and the inventory/sales ratio is lower at 1.12 vs 07's 1.17 (the numbers on an unadjusted bases are even more positive). Like the UPS warning, a slippage here is not that surprising in the face of a slowing economy but at this point it does not appear alarming and we prefer to focus on a more current release, the retail sales data for March due out next Monday. Market expectations are for a return to positive territory at +0.1% with some looking (hoping?) for a rise as high as 0.4%.
Insolvent or Illiquid?
This headline just crossed the tape: DJN: *DJ Bear's Schwartz: Bank Run Prompted By Unfounded Rumors. Really. Given the significant suspicions behind the moves by the Fed to have JPM take over BSC (as well as take onto its own books $29B in mortgage related assets) it is time for the Fed, BSC and JPM to answer the simple question: What caused BSC to fail over that weekend? Simultaneous to the announcement of JPM taking over BSC, the Fed announced a new lending facility open to all primary dealers, of which BSC was one.CEO Schwartz would like us to believe that BSC was simply illiquid - that they could not raise funds by repo or credit lines or any other means as the counterparts were refusing their name. If that is so, why was the new Fed facility either (a) not available to BSC and/or (b) not sufficiently large to fund BSC until they were able to re-establish their credit worthiness in the market place, either by audit or additional capital injection?
Or was it the case that upon review, the Fed decided that BSC was not just illiquid but that they were for all intents, insolvent too and that any 'value' in the firm - 'goodwill' and the possible excess of assets over liabilities - could not be quickly realized and were not material in light of the size of BSC's balance sheet and funding requirements. In fact, most commentators when speaking of a valuation on BSC placed most of the value on its real estate and the good will of a few specific subunits. There is likely value, though hard to quantify, in the intellectual property of BSC.
We would have preferred to see Wall Street handle the demise of BSC on its own, perhaps with some strong arming by the Fed and Treasury department as happened with LTCM. Had the 'crisis' continued another few days it is likely some solution could have been found, perhaps involving group ownership through a holding company by a large number of banks and brokers thus limiting individual risk while preventing the wholesale liquidation of the assets of BSC.
However, the Fed did what it clearly thought was most prudent at that moment in time. But they have not answered the important question of illiquidity or insolvency. If BSC was simply illiquid then the Fed has gone well out of bounds by picking a winner and loser and forcing the sale of BSC to JPM while offering cash flow to others. The American people and the financial markets in particular, need to know the real answer.
The Fed In Space
On Monday there were a few comments from Treasury Secretary Paulson in regards new regulatory proposals and the potential for increased powers at the Federal Reserve bank. This one in particular:DJN: *DJ Paulson: Fed Should Go Wherever `It Thinks It Needs To Go`got us to thinking.....
queue music...
CDOs...
the final frontier...
these are the voyages of the Starship Fed...
our open-ended mission: To explore strange new structured products
To seek out hidden risk and astronomical losses
To bodly go wherever the fuck we think we need to go!
starring....
Hank Paulson as Capt. Kirk
Ben Berspankme as Spock
Jim Cramer as Dr. McCoy
and an assortment of red shirts from Wall St.
The Doomsday Machine
special guest Alan Schwartz as Commodore Matt Decker
...scene opens on the heavily damaged BSC...
[Kirk] Matt. It's Jim Kirk.
[McCoy] Commodore? Commodore Decker?
[Kirk] Matt? Matt.
[Decker] Kirk. It's Jim Kirk.
[Kirk] What happened to your bank, Matt?
[Decker] My bank ... Attacked! That -- That thing.
[Kirk] What was it?
[Decker] That --
[Kirk] Answer me! What was it? What happened, Matt?
[McCoy] Jim, give him a minute. He's in a state of shock.
[Scotty] Ready with the duplicate log, sir.
[Kirk]Go.
[Matt Decker] CEO's Log -- Feddate 4202.1.
Exceptionally heavy market interference
still prevents our contacting Fedfleet
to inform them of the destroyed CDO tranches we have encountered.
We are now funding CDO L-374.
Risk Management Officer Masada reports the equity tranche is breaking up.
We are going to investigate.
(pause)
The equity tranche. Only two tranches left now.
[Kirk] Scotty, beam the microSD to Spock.
I want a complete report of what happened
when they tried to fund that CDO.
[Decker] We tried to contact Fedfleet.
Uh, no one heard. No one!
We couldn't fund.
[Kirk] What happened to your crew?
[Decker] I had to cut their pay.
We -- We were dead.
No liquidity, our repos useless.
I stayed behind, the last man.
The CEO, the last man in the bank.
That's what you're supposed to do, isn't it?
And then it hit again
and the, uh, credity facility went out.
They were down there, and I'm -- I'm up here.
[Kirk] What hit? What attacked you?
[Decker] They say there's no devil,Jim, but there is.
Right out of hell, I saw it.
[Kirk] Matt, where's your staff?
[Decker] Funding the third trache.
[Kirk] There is no third tranche.
[Decker] Don't you think I know that?
There was, but not anymore.
They called me. They begged me for liquidity,
400 of them! I couldn't. I -- I couldn't.
[Scotty] Captain, Washburn has our report.
[Kirk] Go.
[Scotty] We made a complete check on structured products and CPDO's.
As far as we can tell, something crashed through the debt covenants
and knocked out the credit facilities.
Somehow the liquidity in the short term lines has been deactivated.
[Kirk] Deactivated?
Scotty, could some kind of general liquidity dampening field do that,
and would the same type of thing account for the heavy market interference?
[Scotty] Aye, that all adds up.
[Kirk] What thing could do all that?
[Decker] If you'd seen it, you'd know.
The whole thing must be a weapon.
[Kirk] What does it look like?
[Decker] Well, it's -- it's miles long,
with a maw that could swallow a dozen boutique investment banks.
It destroys collateral and balance sheets, rips them into pieces.
[Kirk] What is it, a commercial bank? Or is it a government agency --
[Decker] Both or neither. I don't know.
[Kirk] Matt, your log stated
that the fourth tranche was breaking up.
You went in to investigate.
[Decker] We saw this thing hovering over the debt,
slicing out chunks with a force beam.
[Kirk] What kind of a beam?
[Decker] Pure anti-liquidity. Absolutely pure.
[Beep Beep]
[Kirk] Kirk here.
[Spock] Spock here, Captain.
Unable to raise Fedfleet Command
due to heavy market interference.
Attempting to remedy.
[Kirk] What about the BSC's tapes?
She was attacked by what appears to be essentially ... a robot,
an automated weapon of immense size and power.
Its apparent function is to smash investment banks to rubble
and then digest the assets for profit.
It is, therefore, self-sustaining
as long as there are investment banks for it to feed on.
[Kirk] A robot weapon that purposely destroys entire financial systems. Why?
[Spock] Unknown, Captain.
Moral Crisis
The Chairman of the Federal Reserve Bank is once again out front leading the charge to destroy the US financial system. Inflation is alive and well (unless you happen to live in that fantasy world called Coreland) and the currency is in the tank. Perhaps we can forgive the rise in grain prices as ethanol, a prime culprit, was the creation of our wonderful Congress. Recently, however, Bernanke has moved well beyond his disdain for sound monetary policy by jumping feet first into the sub-prime/securitized asset fiasco. Joining with Treasury Secretary Paulson, Bernanke last year advocated reducing interest rates on sub-prime mortgages to those borrowers 'in trouble' and subject to foreclosure. A number of analysts and commentators pointed out the significant moral hazard such actions would put into play: a bail-out of borrowers who borrowed more than they could service; a bail out of borrowers stuck with properties they intended to flip but had insufficient capital to carry through a downturn; a bail out of borrowers who covered their ears so not to hear the adage 'if it sounds to good to be true...' ; a bail out of lenders (banks) who would be required to provide liquidity to various other entities holding sub-prime mortgage paper and CDO's; arbitrarily changing the terms of legal agreements without the consent of all parties involved; causing potential serious harm to third or higher parties involved in derivative transactions against other investors closer to the original mortgage. The list goes on but many believe the end effect would be to raise future borrowing costs as lenders adjusted their pricing to reflect the new reality that a loan is only to be considered contractually valid when times are good and that terms may be changed adversely at a later date to provide relief to the borrower at the expense of the lender.Moral hazard was not sufficient for Mr. Bernanke as he apparently prefers to see a moral crisis. In a speech he gave to an audience in Florida yesterday Mr. Bernanke proposed that in addition to other measures, lenders should also reduce the principal outstanding.That's right - Bernanke thinks the most irresponsible borrowers should be rewarded not just with a lower interest rate (like one fixed at their introductory ARM teaser rate) but they should also be forgiven whatever negative equity their transaction has created. Have a $300,000 loan on a house now only worth $250,000? Big Ben thinks your lender should give you a mulligan either give you $50,000 against a new loan with another lender or rewrite the current loan to reflect a new principal due of $250,000. Beyond the impracticality of this idea - what on earth could be the justification?
To date, permanent modifications that have occurred have typically involved a reduction in the interest rate, while reductions of principal balance have been quite rare. The preference by servicers for interest rate reductions could reflect familiarity with that technique, based on past episodes when most borrowers' problems could be solved that way. But the current housing difficulties differ from those in the past, largely because of the pervasiveness of negative equity positions. With low or negative equity, as I have mentioned, a stressed borrower has less ability (because there is no home equity to tap) and less financial incentive to try to remain in the home. In this environment, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.So lets try to understand this. Bernanke is trying to justify cutting the outstanding loan principal because this will somehow give 'incentive' to stay in the home? Or if the principal is reduced far enough, there might be some positive equity the homeowner could borrow against!?! This is patently insane. -more-
We're Back!
Just a quick note - we plan on getting Rant going again on a regular basis over the next few days. Regular readers will note that the site went on hiatus from November until this week. The layout is slightly changed (and evolving) but the content will be similar, though the politics category may see less emphasis while defense/intel issues garner more focus. In addition, we plan on following a 3 - 4 times a week posting schedule to keep the post quality higher than your average blog. Thanks for your continued support.Gimme Gimme Gimme
The equity and bond markets the past week have reverted back to their pre-Fed cut state. Just like a crack or heroin addict who's last fix has worn off, the money houses and speculators are asking, no demanding, that the Federal Reserve once again cut the funds rate by at least 25bp - just a month after they reduced it by 50bp. Why? Apparently because Ben Bernanke's schwartz was smaller than the demographics pounding the housing market into submission. That and Wall Street has yet to find buyers for the mountain of collateralized mortgage and leveraged buyout debt they would like to get off the books.Yet since that rate cut what have we seen? The DJIA has risen 500 points or 3.8% (at one point it was 900 pts), the yield curve has steepened and the front of curve is either side of 4.0%, the dollar has continued its merry plummet (down 3.9% against the Euro), corn prices are 10% higher, sugar +5.6%, palladium +13.4%, aluminum +7.3% and gold + 10.7%. Ok - lumber is -5.5% and wheat is flat. But if the complete lack of parking spaces at each shopping center and mall we drove to Sunday mid-afternoon (we recorded the football game so don't be too alarmed) is any indication of retail activity - the consumer is out there in force, in a big way. To say we were shocked is an understatement. Where is the money coming from? Rising wages? Credit card lines?
So will the Fed give the crack addicts another fix and feed the inflation bear at the same time? Or will some common sense prevail and they walk away after prescribing some long term rehab for the housing (and bond) markets?
Bernanke Shock
Did Bernanke rain on Wall Street's day again? A number of comments came out of his speech last night with the main stream media seeming to pick up on 'possible additional Fed rate cuts' as a good lead. We're not quite sure how they put that together, except perhaps as a result of most interviews being with mortgage lenders or others associated with that industry who have a vested interest in the Fed doing just that. However, what probably has Wall St. a bit more concerned is Bernanke's observation that while the broader financial markets have appeared to stabilize, those directly related to housing are still in poor shape. No shock there as the ills in the housing market and the associated lending/derivatives markets will only be fixed by the passage of time, not cheaper overnight rates. In addition, Bernanke made a very unsavory comment - that the Fed may in fact need to take back the 50bp cut from last month should inflation remain elevated or increase.With energy prices remaining high (oil at a record), gold over $750, grains near record highs or at least much higher than the prior year and most metals in the same boat it is no wonder the Fed remains concerned about inflation. In addition, the producer price index that was reported last week showed a large jump in the core crude goods component. That is inflation down the road. Labor costs as reported in the monthly NFP data were also elevated.
Last, the very recent trend in the stock market has been to buy US companies which have large exports, especially to the Eurozone. However, with ECB retaining a firm policy stance and the IMF indicating a slowdown in European growth is a distinct possibility, Wall Street may find themselves holding fools gold once again.
