Tuesday, July 31, 2007

The S&P Case-Shiller Existing Home Price Index is Down 2.8% from Last Year

The Case Shiller Existing Home Price Index is down 2.8% on a YOY basis for May as reported by Market Watch. I am not sure how the index works, but I continue to ask the same question about those cities where prices are up. Is this due to actual increases in the price of homes or is it because the low-end homes are not selling, thereby increasing the average price of homes sold?

Also if you would like another take on the housing market the video of the interview of James Cramer at HousingDoom.com via Calculated Risk is interesting and entertaining in a James Cramer kind of way.

Home prices in 15 of 20 major U.S. cities were lower in May compared with the previous May, Standard & Poor's reported Tuesday.

The Case-Shiller 20-city index fell 2.8% compared with a year earlier, S&P said. That's the biggest decline in the seven-year history of the index.

In 10 major cities, prices were off 3.4% from the previous year, the largest decline since 1991.
"At a national level, declines in annual home price returns are showing no signs of a slowdown or turnaround," said Robert J. Shiller, chief economist at MacroMarkets LLC., and the co-inventor of the price index.

A year ago, prices were rising at close to a 10% pace.

Prices fell furthest in the Detroit metro area, off 11.1%. Seattle had the best gains, up 9.1%. The other cities with price gains were Charlotte, N.C., (up 7%), Portland, Ore., (up 5.7%), Dallas (up 1.8%) and Atlanta (up 1.7%).

Chicago became the latest casualty of the housing bust, with prices now down 0.6% in the past year.
On a month-to-month basis, prices rose in eight of the 20 cities, compared with only one city gaining earlier this year, Shiller said. "We need a few more months of data, however, to determine if this is the beginning of a national turnaround, since the national trend is still at a sharp deceleration." Home prices have been decelerating for 18 months.

New England markets, which were among the first to fall, could be bottoming. Boston has seen prices rise 1.4% in the past two months, but prices are still down 4.3% in the past year.
Cities with falling prices:

Detroit, down 11.1: San Diego, down 7%; Tampa, Fla., down 6.7%; Washington, down 6.3%; Phoenix, down 5.5%; Boston, down 4.3%; Las Vegas, Nev., down 4.1%; Minneapolis, down 3.5%; San Francisco, down 3.4%; Miami, down 3.3%; Los Angeles, down 3.3%; Cleveland, down 2.8%; New York, down 2.3%; Denver, down 1.4%; and Chicago, down 0.6%.

Some “What-ifs” for Consumer Spending

The excerpts below are from a short article written by the folks at Northern Trust, discusses possible changes in consumer spending if the consumer can only rely on disposable personal income (DPI). In light of my on-going posts about the possibilities of a recession due to lower consumer spending it is worth a read.

No Worry about Consumer Spending So Long As Jobs/Income Are Growing? That’s the rallying cry of the economic bulls. Aside from the fact that jobs and personal income are coincident indicators, not leading indicators, and that labor compensation as a percent of consumer spending tends to rise just before the onset of recessions, will jobs and income growth alone be enough to sustain real consumption growth going forward? That is, with mortgage equity withdrawals drying up and corporate buybacks and private equity buyouts slowing down, suppose that consumer spending relative to disposable income reverts to its mean. What rate of growth in real consumer spending could we look forward to in 2007?

There is little doubt, in my mind anyway, that the higher ratio of consumer spending relative to disposable personal income has been the result of increased household borrowing using residential real estate as collateral and the sale of household direct and indirect holdings of corporate equities to corporations and private equity syndicates. If households had to depend only on their income from employment and other sources to fund their consumer spending, we would observe much slower growth in consumption expenditures. So, those who keep harping that “the consumer” will be just fine so long as there is job and income growth ought to do some “what ifs.”

Monday, July 30, 2007

The “L” Word – Liquidity

Excerpts below from an article in the WSJ concerning liquidity is a very good discussion of the subject. The issue that has been mentioned on this blog a number of times about liquidity is that “it is there until it isn’t”. If you want to understand the stock market it is important to understand the “L” word.

A flood of money sloshing around the world the last few years has helped drive up the price of everything from commodities and stocks to junk bonds and emerging-market debt. The catch phrase for all this money is "liquidity." Now that the markets are in spasm, it makes sense to look at where the liquidity came from and where it is going.

Money is created by central banks, and amplified by the institutions that use it -- banks, hedge funds, investors. The more confident they are, the more easily it flows. The liquid world leaves everyone with more investment, and also more debt.

Low interest rates are a sign money is cheap and easy. Central banks like the Federal Reserve have been the primary liquidity mop the past few years, boosting interest rates to clamp down on inflation after unleashing a liquidity gusher back in 2001, after the Sept. 11 terrorist attacks. Japan's central bank has stoked the liquidity furnace; it still has rates below 1%. Hedge funds, banks and pension funds borrowed the cheap cash and deployed it around the globe.

Today, fear is another liquidity sponge. It tightens the lending that drives liquidity. Mortgage lenders are clamping down on risky loans after a jump in subprime-mortgage defaults. Banks have started calling in collateral from hedge funds that dabbled in exotic securities linked to subprime loans. Meantime investors are thumbing their noses at banks trying to sell them loans or junk bonds used by private-equity firms to finance leveraged buyouts. It all means less money for investment.
"A necessary component of liquidity is risk taking. When market participants want to reduce risk, they don't make loans," says John Succo, partner of the New York hedge fund Vicis Capital. . . . .


. . . . The world's financial architecture is different now. The proliferation of hedge funds and derivatives has theoretically spread risk around, making a Long-Term-like event less likely. It's also far more complex. Unknown problems could lurk in today's derivative jungle, and quick fixes like the one that cured the Long-Term debacle might not be as effective.

Confused About Where the Stock Market is Headed Next – So Are the Experts

The brief excerpt below is from an excellent WSJ article concerning the debate about where the stock market is headed next. The full article is a very good summary of opposing positions on the future of the current bull market. The entire article is worth a read.

Last week's stock-market carnage -- the Dow Jones Industrial Average fell 4.23% for the week to 13265.47 -- seemed an overreaction to most analysts, who focus on fundamentals like corporate profits and interest rates. The global economy continues surging, they point out, while most market interest rates remain low by historical standards. What matters, they say, is whether the credit crunch, caused by ill-conceived loans to home buyers and businesses, starts to interfere with growth and interest rates.

But another, less fashionable, breed of analysts sees storm warnings. Known as technical analysts or chartists, because they plot and compare a wide range of sometimes-arcane market data on graph paper and spreadsheets, they liken their work to hurricane tracking. They can see a pattern building, they say; the trick is distinguishing a brutal Category 5 storm from a less-severe Category 2.

Sunday, July 29, 2007

Credit Market Fall-Out #14 - Scorecard of Upcoming Debt Issues or Hedge Funds

The link to a scorecard from the WSJ of hedge funds or upcoming debt issues with problems is interesting to look over. Lots of firms with either pulled offereings or changed terms.

Based on the Q2 GDP Numbers from the BEA the Economy is Continues to Weaken

Examination of the GDP numbers from the US Dept. of Commerce Bureau of Economic Analysis (BEA) indicates that the economy is weakening and showing the early signs of going into a recession. The analysis used to determine this is different from that completed by the BEA and widely reported by the financial press. The specifics of the analysis used are as follows:

The data used is real, seasonally adjusted GDP.

Real GDP values are used to eliminate the effects of inflation in the analysis.

The BEA reports changes in GDP growth on a quarter over quarter basis (QOQ). I use year over year (YOY) analysis. This is done to reduce the noise in the analysis. Further, anyone familiar with sales or loan growth analysis will tell that YOY analysis is used because the Q4 is not comparable to Q1, Q1 is not comparable to Q2, etc. because the business dynamics in each quarter are different. For example, retail sales are strongest in Q4 for many industries and slowest in Q1. Therefore, the best comparison for Q4 data is Q4 data from the previous year. The YOY analysis tells you how good you did since last year. The same is true for the economy at large.

With all that said the YOY analysis of real, seasonally adjusted GDP values indicates a slowing economy:

Real GDP grew only 1.78% from the same period (Q2) last year. YOY economic growth has been falling for the last 4 quarters.

The Personal Consumption Expenditures (PCE) growth rate, the fancy term for consumer spending which makes up 71.6% of real GDP, fell again for the second straight quarter to 2.90%. The problem with this value is that it is below what many believe is the important 3% growth rate level required to sustain the economy. As an aside the weakest growth in the PCE is in non-durable goods.

The growth rate for Gross Private Domestic Investment (GPDI), which makes up 16% of GDP, dropped just over 6%. This is the 4th straight quarterly decline in GPDI and is due mostly to declines in fixed investment and residential construction (double click to enlarge the graph below).



Net export growth, the international trade component which is a relatively small portion of GDP, had a decline of just over 7%.

Government spending growth, which comprises 17.5% of GDP and is largely driven by state and local government spending, remains relatively constant at just under 2%.

When you add up all the numbers it spells out a relatively weak economy with a weakening consumer spending sector and a very weak private or industrial sector.

Admittedly, these numbers will be revised twice before the Q3 numbers come out at the end of October, but the ultimate picture will not change that much.

With a weaker consumer spending anticipated in the Q3 and a real estate market that continues to weaken it is difficult to be optimistic about the prognosis for the economy going forward. I would not be surprised if the economy continued to slide downward where negative GDP growth is reached in Q3. What happens next will depend on the reaction of consumers and businesses to the news. My guess is:

The real estate market will continue to contract as the home-owners with ARMs obtained in the last part of 2005 and 2006 continue to reset over the next 18 months.

The consumer will reduce spending further in response perceived and real loss of wealth due to declining housing and stock markets.

Businesses will react to weak consumer spending (demand) by restraining employment growth, which will further dampen consumer spending.

The net effect of all of this is a weaker economy over the next two or three quarters. Whether this causes a recession or not will depend largely on the ability of the consumer and businesses to keep spending. Let’s face it, when the consumer and business controls 87.6% of GDP, the economy goes they go.


An increase in energy prices, a crash of the stock market, or the bond market are unpredictable outside shocks to the system that will only exacerbate the problems of a loss in wealth of the consumer further weakening the economy

Friday, July 27, 2007

Credit Market Fall-Out #13 – The Problems in the US are Spreading Overseas

The problems that we are experiencing in the US are spreading overseas, from Market Watch. This was expected and it demonstrates how linked the various international markets are. The question is, what is the level of coupling (de-coupling) that exists between the US credit markets and similar markets overseas.

Behind the latest sell-off in the Dow Jones Industrial Average was an erosion in credit-market confidence that has plunged international corporate bonds along with emerging-market debt into an accelerated retrenchment, analysts said.

"The fact is we live in a general equilibrium world," said Paul Kasriel, chief economist at Northern Trust. "Everything affects everything else and [the U.S. housing slowdown] is spreading to other parts of the economy and the credit markets."

What began in recent months with the collapse in the subprime-mortgage financial sector has led to a ripple effect devastating a number of hedge funds, including two that are part of Bear Stearns.


Increasingly investors are refusing to provide Wall Street firms with cheap money to finance leveraged buyouts, a key source of support for the stock market. Some defensive institutions reacted this week to unsubstantiated market rumors about German and Japanese funds taking a hit from bad U.S. home loans, Kasriel said.

. . . . "This is a global problem," said T.J. Marta, fixed-income strategist at RBC Capital Markets. "Optimists say that because the markets are global we are spreading out the gain, but also spreading any losses."

"Pessimists say that the issue will hit a psychological tipping point and because it is a global problem it will be felt broadly in many places," he said. . . . .

"The private-equity players were able to convince the investment banks to guarantee funding at very high leverage levels," he said. "The problem is that banks now have a huge number of pending deals that outside investors aren't willing to buy. That's going to put a lot more pressure on secondary markets."

On Wednesday, the $10.3 billion leveraged buyout of popular U.K. retailer Alliance Boots PLC was delayed because banks arranging financing for buyer Kohlberg Kravis Roberts failed to sell senior loans backing the deal.

. . . . John Atkins, fixed-income analyst at IDEAGlobal.com, said the delay in the Boots deal is souring the mood for bond markets in continental Europe, where investors tend to more risk-averse than in the U.S.

"Will there be big differentials for the LBOs and their underwriters between here and Europe, where syndicates tend to be more risk averse than [in the U.S.]?" Atkins said.

"That's going to be a big issue," he said. "If it's getting this bad in the U.S., it's going to be much worse in Europe.

Thursday, July 26, 2007

Credit Market Fall-Out #12 – The CLO Market is All But Shut Down

This article from Market Watch discusses the CDO market (mortgages) and its effects on CLOs. Basically the demand for these types of debt instruments is coming to a close. It will take some time for the markets to clarify, that is determine who is going to take the losses in the CDO markets, before demand for CDOs and CLOs increases. As a result of this uncertainty in the credit markets expect more bad days in the stock markets.


The market for Collateralized Loan Obligations has almost shut down in recent weeks, making loans for leveraged buyouts and corporate borrowing harder to sell, experts said Thursday.

CLOs are packages of leveraged loans that are sold by investment banks to hedge funds and other institutional investors. Roughly $100 billion of the vehicles were issued in 2006 and about $58 billion were sold in the first half of 2007, according to Steven Miller, managing director of Standard & Poor's Leveraged Commentary & Data.

The fast-growing market helped fuel the leveraged buyout boom in recent years, which in turn has been a major driver of stock market gains. However, that trend has stopped abruptly in recent weeks, Miller and others said.

"It's absolutely shut down for any new CLOs in the last two weeks," said Kingman Penniman, president of KDP Investment Advisors, an independent research firm focused on high-yield bonds and leverage loans.

Existing CLO deals continue to progress, Miller said, "but the market for brand new deals getting a financing line and warehousing has shut."

"That's very important," Miller added. "The CLO market has been the cornerstone of the leveraged loan market. Lower demand from CLOs means it's harder to sell loans."

Part of the problem is that many of the natural buyers of CLOs also bought Collateralized Debt Obligations (CDOs), KDP's Penniman said.

CDOs are a bit like mutual funds that buy asset-backed securities. Those vehicles snapped up a lot of the riskier bits of subprime mortgage-backed securities in recent years, helping to fuel the housing market boom. But subprime mortgage delinquencies have jumped and some CDOs have been downgraded, leaving investors suffering losses.

"When these investors started to realized there were problems and losses in CDOs, that caused widespread concern and risk aversion that basically shut down the CLO market," Penniman explained.


Another concern for investors is that there are more than $200 billion of leveraged loans and about $100 billion of high-yield bonds that need to be sold in coming months, many of which will help finance leveraged buyouts that have already been announced, Penniman and others noted.

"Investors are holding back, knowing dealers have large inventories," Chris Flanagan, head of global structured finance research at J.P. Morgan Chase

"Investors are still grappling with the implications of subprime turmoil" and remain "unwilling to step in until there is more clarity," he added.

Another Opinion About the Condition of the Credit Markets

When the DJIA drops 300+ points in one day the news stories about bad news come out of the woodwork. None the less, this article from Market Watch is worth a read.


No one knows what is going to happen! However, there is sufficient bad news out there to make sure that everyone should be covering their risks. Were you out of the market?

The problems in the U.S. subprime mortgage market could spiral out of control into a global financial crisis, economist Mark Zandi said Thursday.

With a "high level of angst" in the financial markets about who will take the losses from more than $1 trillion in risky mortgages, we could be just one hedge-fund collapse away from a global liquidity crisis, said Zandi, chief economist for Moody's Economy.com.

A global meltdown is not likely, but the risks are growing, Zandi emphasized in a conference call with reporters following the release of a new study on subprime debt that concludes that the housing crisis could be deeper and last longer than investors now believe.

In a note to clients on Wednesday, Goldman Sachs chief economist Jan Hatzius said the housing correction could be less than half over, if history is any guide.

"The dramatic deterioration in the mortgage market suggests at least the possibility that the credit crunch in the mortgage finance industry could become as bad as in the bad old days of the 1970s and 1980s," Hatzius wrote.

"If there's another major hedge fund that does stumble, that could elicit a crisis of confidence and a global shock," Zandi said. The potential "is quite high," he said. He gave it a one-in-five chance.


Zandi said global financial conditions have been supported by strong growth and substantial liquidity, supercharged by "unprecedented risk tolerance." But that's changing. Global liquidity is drying up, with central banks tightening. And risk is being re-priced.

As for the U.S. housing market, Zandi expects a lot more pain, but not a recession. Here I disagree.
I expect a recession to start sometime in the 2nd half of 2007. The only thing keeping the economy out a recession is the consumer and they are beginning to struggle. Once the consumer pulls back on spending the unemployment rate will begin to increase as producers respond to weak demand. Once this happens the economy will slide into a recession.

Here are some highlights of his forecast, based on a study using anonymous data collected by consumer credit agency Equifax:


Home prices will fall 10% from the peak nationally, more in the bubble regions in California, Florida, Nevada, Arizona and Washington, D.C.

Home sales could bottom later this year, home construction could bottom early next year, and house prices could bottom late next year. It'll be 2010 before the housing market could be termed "normal."

About 17% of total mortgage debt is at risk, totaling about $2.5 trillion in subprime, Alt-A and jumbo debt. About $1.4 trillion is at serious risk of default. Investors will lose about $113 billion as $460 billion worth of mortgages default.

About 20% of the subprime loans written in the last half of 2006 will fail, with the peak of the defaults not coming until 2011. A "significant number" of these borrowers never made a single payment.

More than 2.5 million first mortgages will default this year and next year. Subprime borrowers will experience significant financial distress.

The U.S. economy will grow less than 3% annualized through the middle of 2009. A healthy job market should prevent a recession, although the jobless rate will likely rise to 5% from 4.5% by the end of the year.

Consumer spending has already slowed and will slow further.

Sales of Existing Homes Down in June

The article from Market Watch gives the current status of the real estate market. The information continues to indicate a market that is slowing with no indication of where the bottom may be.

Sales of U.S. existing homes dropped 3.8% in June to a seasonally adjusted, annualized rate of 5.75 million units, the lowest sales pace in nearly five years, even as frustrated sellers pulled their homes off the market by the thousands.

Sales of single-family homes plunged at a 30% annual rate in the second quarter, the steepest decline in 28 years, the National Association of Realtors said Wednesday. Sales of single-family homes were down 12% in June compared with a year earlier.

Even with a significant 4.2% drop in the number of homes for sale, the supply remained at a 15-year high at 8.8 months' worth of sales.

"The numbers were not terribly surprising, but they were somewhat disturbing, " said Mike Schenk, senior economist for the Credit Union National Association. "The slump in housing will be longer and deeper than advertised."

Inventories of unsold homes on the market fell by 180,000, or 4.2%, to 4.20 million, representing an 8.8-month supply at the June sales rate.


June's sales fell in all four regions, dropping 7.3% in the Northeast, 6.8% in the West, 2.8% in the Midwest and 1.7% in the South, according to the NAR's data.

Sales of single-family homes dropped 3.5% to a 5.01 million annual pace, the lowest since September 2002. Condo sales fell 6.3% to 740,000 annualized.

The Fed’s Beige Book Shows A Mixed Economy

The beige books shows a mixed economy with some regions slow while others having mixed or improved economic conditions. The article is at Market Watch and the original report can be found at the Fed.

Fed districts banks in Kansas City and Dallas reported decelerating growth, while Boston and Atlanta said conditions were "mixed." On the other hand, seven regions reported "modest" or "moderate" growth, while only Philadelphia reported "improved" conditions.

The tenor of the report suggests that the economy is not especially robust at the start of the second half of the year.

Consumer spending rose at a modest pace, but four of the 12 Fed banks reported sales as "mixed" or "below expectations." There was a sense that high gas prices had restrained spending.

Sales related to housing -- such as furniture and home repair materials -- were weak or declining, the survey found.

New car sales were described as "lackluster" or "flat" in many areas.

The housing sector continued to decline, but there were signs of stirring in some areas, the survey said.

Household lending declined in most regions and several districts reported decreasing demand for mortgages and tighter underwriting standards.

But there were also signs of strength in the economy.

Business spending was mentioned frequently in glowing terms. In addition, labor markets appeared to remain tight as employment increased in most regions and in many sectors of the economy. Another positive factor was strong export demand in a number of districts.

Commercial construction and office real estate were generally more active than during May and June, the report said.

There were cost pressures for businesses but prices at the retail level continued to increase at a moderate rate, the study found. Wage gains were also moderate.

Wednesday, July 25, 2007

Transport Growth Slows – An Indication for the Economy

Just in Case you always wondered why the Dow Jones Transportation Index was important, the following from the WSJ explains why it is a precursor for the economy in the next 2 – 5 months.
The freight slowdown that began last year is rippling through the second-quarter results of big transportation companies, whose largely disappointing profits indicate the weak housing and manufacturing markets, on top of high fuel prices, remain a drag on economic growth.

Weaker consumer spending is prompting retailers and other customers to withhold inventories and delay the start of the peak shipping season, railroads and other freight carriers said.

The shipping rush was expected to begin in late summer and turn around flagging freight volumes. But UPS and Burlington Northern expressed uncertainty about the strength of the coming period, when trains, trucks, planes and ships are packed with goods from Asia and other overseas markets ahead of the holiday shopping season.

Many consumers, feeling pinched by escalating gasoline prices and higher prices on retail products, have reined in spending. Economists at Global Insight estimate that annualized consumer spending slid to 1.2% in the second quarter from 4.2% in the first quarter. Retailers have responded by putting off shipments to replenish their shelves, making them a "wild card" as UPS tries to prepare for the season, said Scott Davis, UPS's vice chairman and chief financial officer.

Credit Market Fall-Out #11 – An Assessment From Moody’s About the Credit Markets

Below is an assessment from Moody’s about the credit markets from Bloomberg. I tried to get the original report from Moody’s but did not have much luck. My problem with their assessment is that as long as there is liquidity there should be no disruptions in the market. The issue with liquidity is that it is there until it isn’t.

The credit market rout caused by the slump in U.S. subprime loans gives ``serious reasons to worry'' and is a ``reality check,'' without posing a systemic threat, according to Moody's Investors Service.

While the turmoil has caused some investors to reassess credit risk, others are ready to acquire assets at lower prices, given the ``ample liquidity'' available, Moody's said in the report. The readiness to buy means there is no generalized threat to the integrity of the financial system, Moody's said.

``Risk reappraisal is welcome at this juncture,'' the analysts wrote. ``It does not have to generate disruptions of a systemic nature.''

At least 35 bond and loan deals worldwide were canceled or restructured in the past five weeks because of turmoil caused by losses in subprime mortgages. . . . .

The Moody's report is titled ``Summer 2007: Another False Alarm in Terms of Banking Systemic Risk but a Reality Check,'' and was prepared by a team of analysts led by Pierre Cailleteau, the New York-based firm's chief international economic analyst.

The collapse of the Bear Stearns hedge funds has caused investors to shun collateralized debt obligations, securities that repackage bonds, loans and their derivatives into new debt. Demand from CDOs for new debt was one of the engines behind a credit boom in which financial companies gave mortgages to people with poor credit histories and little or no documentation.

Investor ``nervousness'' probably will endure until the size and location of losses is known, the analysts said. This ``is unlikely to be soon and headline risk will probably test markets' nerves,'' according to Moody's.

Tuesday, July 24, 2007

Credit Market Fall-Out #10 – Looks Like the Market is Beginning to Slow Down

With all the problems the credit markets are having given losses, rating uncertainties, value issues, etc. it was inevitable that the market would slow down. The question is how will this effect the lending markets for new mortgages. The mortgage companies and banks are not going to make sub-prime loans and hold them in their portfolio. Also there is a lot of fee income that the investment banks are no longer going to earn. Lastly, what will be the effect on the stock market when this spills over into the leverage buy-out (LBO) market. I still think the 2nd half of 2007 will be pretty interesting to watch - from a distance. From Bloomberg:

The Wall Street money-machine known as collateralized debt obligations is grinding to a halt, imperiling $8.6 billion in annual underwriting fees and reducing credit for everyone from buyout king Henry Kravis to homeowners.

Sales of the securities -- used to pool bonds, loans and their derivatives into new debt -- dwindled to $3.7 billion in the U.S. this month from $42 billion in June (my emphasis), analysts at New York-based JPMorgan Chase & Co. said yesterday. The market is ``virtually shut,'' the bank said in a July 13 report.

Investors are shunning CDOs after the near-collapse of two hedge funds run by Bear Stearns Cos. that owned the securities. Standard & Poor's downgraded bonds from 75 CDOs as mortgages to people with poor credit defaulted at record rates. Concern about losses on home loans are rattling investors across the credit spectrum.

``We're walking on thin ice,'' said Alexander Baskov, a fund manager who helps oversee $25 billion of high-yield debt for Pictet Asset Management SA in Geneva. ``People are trying to find value and the right price and right now nobody knows what it is. Pretty much everyone is in the dark.''

Investors are demanding yields 10 percentage points higher than benchmark rates to compensate for the risk of losses on some of the lower investment-grade rated parts of CDOs, up from 4 percentage points at the start of the year, according to data compiled by Morgan Stanley in New York.

. . . . Banks are becoming more skittish about providing credit lines, called warehouse financing, managers use to buy assets that go into CDOs in the months before the securities are issued, said James Finkel, chief executive officer of Dynamic Credit Partners. The New York-based company manages $7 billion in 10 CDOs and a hedge fund.

. . . . On top of management fees, banks underwriting CDO sales charge underwriting fees as high as 1.75 percent, compared with an average of 0.4 percent for selling regular investment-grade bonds, according to data compiled by Bloomberg. Banks collected $8.6 billion underwriting CDOs last year, according to a report last month by JPMorgan analyst Kian Abouhossein in London. They took in another $3.8 billion from related trading, investing and other activities, the report said.

Monday, July 23, 2007

Another View on the Role of the Regulator

Another view on the role of the regulator that ties in well with the post below. Excerpts from the WSJ article are below the entire article is worth the time. I am still in favor of the regulators using their power to cut-off risky lending practices at the source, thereby protecting the consumer and allowing the firms that take inordinate amounts of risk in the credit markets to fail. Basically, I am not interested in bailing out firms that take on inordinate amounts of risk with the taxpayers money. You want the big return you take on the big risk.

Congress is about to propose new regulations for hedge funds. German Chancellor Angela Merkel has the same bad idea, meanwhile the British Financial Service Authority, currently worrying about excessive debt issued to finance acquisitions by private-equity firms, may be next in line. But whatever the perceived problem, more regulation is not the answer. It is far better to change some incentives for excessive risk-taking. The old saying is true: Capitalism without failure is like religion without sin. (my emphasis) The answer to excessive risk-taking is "let 'em fail."

History has taught us that not only do regulations not rein in excessive risk-taking, but they often do more harm than good. More than 50 years passed before Congress and the regulators repealed mistaken legislation such as the Glass-Steagall Act that prohibited banks from doing business across state lines, or Regulation Q that restricted interest payments on bank deposits. The damage done by the most recent big blunder -- Sarbanes-Oxley -- has proved no less difficult to remove.

Regulation will not solve the problem of risk-taking that has returned many times, under many different regulatory regimes. If there is a current problem of excessive risk-taking, it arises from financing long-term investments with short-term borrowing. This is an often-repeated problem in financial history that ends badly for many of the risk-takers, especially if the economy experiences a recession.

The good news is that risk-taking, even when it fails, has not stopped prosperity from continuing. The world economy enjoys sustained growth. Household incomes are rising. Corporate profits remain strong. As long as this continues, debt-servicing problems will remain limited. One remaining problem is herd-like behavior among managers and portfolio investors. . . .

In conclusion the author states:

. . . . A strategy for reducing risk is overdue. Instead of burdensome regulation, the Federal Reserve and other regulators should develop a strategy, announce it and follow it whenever the next round of failures appears. Bailouts encourage excessive risk-taking; failures encourage prudent risk taking.

Credit Market Fall-Out #9 – The Role of the Regulator

With the dispersion of risk throughout the financial markets, the question arises as to the role of the regulator. Maybe it should be to make certain that risky loans are not made in the first place. Trying to regulate the financial markets is impossible, because as soon as you make a rule someone will figure out a way around it. Therefore, the regulators should be to make certain that risky loans are not made in the first place. From the WSJ.

The mess in the subprime mortgage market is shaping up as an important test of the globe's new financial architecture.

A generation ago, when the U.S. real-estate market seized up in places like California and Texas, banks and savings and loans felt the pain. The government fixed the problem at a huge cost to taxpayers. Since then, financial markets have replaced banks and regulators. Mortgages get bundled into products with strange names -- like collateralized debt obligations or residential mortgage-backed securities -- and sold to investors around the world.

Because the risk gets spread so widely, regulators can do little but watch and try to reassure everybody it is all under control.

This shift to a markets-oriented architecture has been going on for a long time. But it is hard to overstate how dramatically it has changed in the past decade. During the 1997 Asian financial crisis, Thai and Korean banks were at the center of the problem. The International Monetary Fund and U.S. Treasury pushed them to write off bad loans and get cash. When Long Term Capital Management collapsed in 1998, the Federal Reserve called a handful of banks to the carpet to fix the problem.

Whom do you call today? Subprime problems are popping up all over the place: an Australian hedge fund, a little-known investment unit of Bear Stearns, European banks.

In many ways, this is the beauty of the system. Risky investments are dispersed around the globe the way a sprinkle system distributes droplets of water around a lawn. In theory, when trouble hits, the risk is evenly divided and the overall financial system remains stable.

It seems to be playing out that way so far. Subprime losses could hit $100 billion, yet the Dow Jones Industrial Average reached records last week. "The fears about the kind of spread of this to other markets hasn't really occurred," says Wharton School finance professor Gary Gorton.
But there are worrisome downsides to this financial architecture. The system hides risk and concentrates it in hedge funds that regulators and other investors don't understand. The hedge funds have access to huge amounts of debt, allowing them to make big bets on investments that can go wrong very quickly.


"We don't really know where the bodies are buried until after the fact," says Andrew Lo, an MIT professor who also runs a hedge fund.

A system designed to distribute risk also tends to breed it. At their core, subprime loans and other mortgage innovations -- 'piggyback' loans, Alt-A mortgages, 'no-doc' loans -- brought credit to people who wouldn't otherwise have gotten it. Few of these products would have become so popular if they hadn't been packaged into securities and sold widely to investors.

OPEC Believes a Fair Price for Oil is $60 - $65/Barrel

Just to complete the circle on the views for the price of oil, from CNNMoney:

A fair price for both oil producers and consumers for a barrel of oil would be around $60 to $65 a barrel, a Kuwaiti state oil newsletter quoted the head of OPEC's research division as saying.

"A price of $60 to $65 is appropriate for consumers and producers, because it boosts means of investment in the oil industry in light of growing demand for oil in the coming years," state firm Kuwait Petroleum Corporation's (KOC) monthly newsletter quoted Hasan Qabazard as saying.

"OPEC seeks to supply markets sufficiently at proper prices," Qabazard told the magazine's July edition. Qabazard is the top research official at the Vienna headquarters of the Organization of the Petroleum Exporting Countries.

The report did not specify to which oil price he referred. Benchmark London Brent settled at $77.64 a barrel on Friday, just over a dollar below the record of $78.65 hit last August. The price of OPEC's reference crude oil basket stood at $73.23 on Thursday.

Qabazard blamed political problems such as a row between Iran and the West over Tehran's nuclear program and abductions in Nigeria's oil industry for rising oil prices.

Qabazard also said a shortage of gasoline in the United States, as a result of refinery capacity constraints, contributed to high oil

Another Article on $100/barrel Oil

From Bloomberg another article concerning when oil will reach $100/barrel. As before the issue is not necessarily supply or that we are running out of oil, the issue is demand. The US and European consumers are not that sensitive to price increases and demand in China and India are increasing rapidly.

Why the sudden interest in oil? Or is just everyone is tired of talking about the real estate market.

The $100-a-barrel oil that Goldman Sachs Group Inc. said would prevail by 2009 may be only a few months away.

Jeffrey Currie, a London-based commodity analyst at the world's biggest securities firm, says $95 crude is likely this year unless OPEC unexpectedly increases production, and declining inventories are raising the chances for $100 oil. Jeff Rubin at CIBC World Markets predicts $100 a barrel as soon as next year.

Currie, Goldman's global head of commodities research in London, is predicting that oil prices will probably touch a record and stay at unprecedented levels for months or years. The all-time high for Nymex crude futures is $78.40 a barrel on July 14, 2006.

``Ultimately, the key to the outlook going forward is when will Saudi Arabia ramp up production,'' he said in an interview. ``If you have a situation in which inventories globally get drawn to critically low levels, the volatility in this market is likely to explode, which significantly increases the probability of $100 oil.'' Oil might slip to $73.50 if OPEC were to start producing more now, he said.

The Organization of Petroleum Exporting Countries is scheduled to next meet in September. No members have called for a gathering before then. A decision to raise output at that time would lead to greater supplies toward the end of the year.

The failure of near-record fuel prices to restrain global oil demand growth is what concerns Rubin, chief strategist at the brokerage unit of Canadian Imperial Bank of Commerce in Toronto.
``Prices have doubled, and demand is alive and well and accelerating,'' he said in a July 18 interview. ``The argument that rising prices would choke demand and bring increased output is falling to the wayside.''


A National Petroleum Council study led by former Exxon Mobil chairman Lee Raymond, released last week, predicted a growing gap between production and demand for oil and gas during the next two decades. As recently as 2005, Raymond said oil prices had probably peaked and dismissed the possibility that supply and demand could not be brought back into balance. See earlier post.

``It appears that high prices are acceptable to the American consumer,'' said Robert Ebel, chairman of the energy program at the Center for Strategic and International Studies in Washington. ``People want the house with a yard and white-picket fence so they are moving further and further out of the cities. They have to just get up earlier and drive further.''

Outside the U.S., demand increases are being led by India and China, where growing economies mean more cars and trucks and more factories that burn oil and gas.

Consumption between now and the end of the year will increase by 3.6 million barrels a day because of seasonal shifts. The rise is equal to the daily production of Kuwait and Oman combined, and it comes after OPEC twice in the past year cut production to support prices.

Sunday, July 22, 2007

When Will We Get $100/barrel Oil? Maybe Sooner Than You Think.

An interesting article from Canada discussing the future price of oil. I am assuming that you are already planning for this. Correct?

With the way the analytic crowd is kicking around triple-digit oil prices, you'd think central bankers would be pulling out their hair and soaring prices would be capping demand.

But it isn't necessarily so. What we're finding out, courtesy of Jeff Rubin, is that demand for crude is a lot less price elastic than we were led to believe.

Not in the developed economies of the Americas and Europe, mind you, where gasoline taxes and subsidies for bio-fuels have cut crude oil consumption for two years running. But in the developing countries like China and even oil-producing regions like Russia and the Middle East, where demand this year is expected to grow by four times the rate in our backyard.

And all this comes with supply hard pressed to keep up.

"The arrival of $100 (U.S.) a barrel oil is likely to come earlier than first predicted back in 2005, when we pegged the end of the decade as the likely period," said Mr. Rubin, CIBC World Markets' chief economist and strategist. His charts suggest U.S. prices should set a new record high of $80 a barrel this year on tighter markets, climbing to an average of $90 in 2008, and then crossing the unthinkable barrier towards the end of next year.

He's not alone. On Tuesday, Goldman Sachs warned that the price of crude oil could top $90 a barrel this autumn and hit $95 by the end of the year, if the oil cartel keeps oil production capped at current levels.

Sub-Prime Mortgage Market is the Lack of Experience

Another problem in the sub-prime mortgage market is the lack of experience. With no experience it is difficult to be precise (or even analytical) about how long it will last or how bad it will get. From the WSJ:

Participants in the complex world of debt tied to subprime mortgages may not be the rocket scientists they thought they were. But they have a problem rocket scientists appreciate: It's hard to precisely analyze something when the thing is moving.

Wall Street has been rocked as investors have found that many of the collateralized-debt obligations they bought were riskier than expected. CDOs are pooled-together debt instruments that sometimes hold subprime-backed bonds. When the housing downturn gathered steam, subprime delinquencies rose sharply, which is now hitting these instruments.

With the shuttering of two Bear Stearns hedge funds and recent moves by ratings services to cut ratings on billions of dollars of subprime-linked CDOs, market participants might better get the risks.

The problem is the U.S. housing market continues to deteriorate. Nobody knows when it will improve or how bad subprime losses can get. At the end of the first quarter, 5.1% of subprime mortgages were in foreclosure, up from 3.5% two years ago, the Mortgage Bankers Association says.

For a sense of how quickly foreclosures can rise, consider the 1980s Texas oil-patch bust. Back then, foreclosures in the state for all mortgages soared from less than 0.1% of all mortgages in 1981 to 1.9% by 1987. And that was based on mortgages to creditworthy borrowers. Many subprime borrowers never should have gotten loans this time.

The problem, Columbia Business School professor Christopher Mayer points out, is that Wall Street's experience with subprime mortgages isn't deep. Its experience with the exotic mortgages written in the late stages of the housing boom is essentially nonexistent. That makes their reaction to the housing downturn impossible to predict.

"This story is going to be going on for a long time," Mr. Mayer says. "There's no way to fast forward the process."

Weekend Contemplation #2 – Wealth vs. Money

Another article with thinking over, from the WSJ:

The main fallacy in monetary theory and policy is the confusion of money and wealth. Money is wealth from the individual perspective since individuals can usually exchange it for goods and services. Money -- and financial assets easily converted to money -- may not be wealth for society as a whole if the production of goods and services has not kept pace with claims on it. Early spenders may have some success, but inflation will dilute the buying power of others. The bottom line is that real wealth has to be produced; it can't be printed.

Don't call me a Keynesian, but Keynes's Paradox of Thrift is another example of the fallacy of composition -- what's true for the individual may not be true for the group. Most U.S. families should be saving more. Indeed, the personal saving rate -- the percentage of disposable income not spent on consumption -- hovers around zero, with frequent dips into negative territory. This is made possible, for a while, by selling assets, accumulating debt, or spending capital gains in the housing and stock markets. Money obtained by realizing capital gains spends as well as money earned on the job. But not if too many of us try it at once.

The Paradox of Thrift says that attempts to save more in the aggregate reduce consumption spending, which, if not offset by increases in other spending, will reduce total spending and income. The paradox comes in when attempts to save more results in reduced saving out of lower incomes. The irony is that policy makers advise more saving but those who take the advice will benefit only if most of us ignore it, and policy makers are implicitly counting on that outcome.

A parallel is the farmer who hopes for a good crop year. But, if all or most farmers have a good crop year, the decline in prices may more than offset higher yields. What our farmer really needs is a good crop in a bad crop year. Then he could look for a popular restaurant that isn't crowded.
I realize this is not very sophisticated stuff, but it's on my mind because of the many talking heads I hear dismissing the adverse consequences of our low personal saving rate by saying it ignores capital gains as a source of spending. "Properly measured," they say, saving is not a problem.
Again, that may be true for the few, but not for the many. A penny saved may be a penny earned, but it matters whether it was earned by producing more or by a rise in the price of existing financial assets. A stock or housing market boom creates apparent wealth in the form of capital gains, but trying to convert it to real wealth en masse can make it disappear.


Economists say the main reason they worry about the budget deficit or the current account deficit is their impact on domestic saving. But my guess is that only other economists really get their meaning. Most people may be even further misled by the implication they hear that since the main harm of deficits is their impact on saving, they must not be too harmful after all. The old-fashioned notion that deficits are bad because they create debt that must be paid back with interest is probably a better prod to constructive behavior. Or that deficits impose a burden on our children or grandchildren.

Alan Greenspan has been one of the few economists to explain these matters correctly and -- I can't believe I'm saying this -- understandably, usually in the context of Social Security or other entitlement reforms. Whenever confronted by various financial fixes during congressional testimony, he frequently pointed out that any solution to the problem had to include real economic growth. With claims on output growing rapidly, output has to grow equally rapidly, or the claims are bogus. Any solution to our entitlement problems must include a bigger, more productive economy in the future. It's really as simple as not selling more tickets to the Super Bowl than there are -- or will be -- seats in the stadium. Of course, the political preoccupation with distribution rather than production puts unnecessary limits on the size of the economy on Super Bowl day.

The problem goes beyond government entitlement programs. Consider the baby boomers whose IRAs, 401(k)s and personal investments helped drive the stock market to record highs. What happens when cash-in time comes? There will be a mountain of paper claims on output, but will there be an equally tall mountain of output?

The great French economist, Frederic Bastiat, said that "The state is the great fictitious entity by which everyone seeks to live at the expense of everyone else." It's time to get real about producing real wealth, not just financial claims on wealth.

Weekend Contemplation #1 – The American Dream?

Some interesting comments concerning the anxiety about achieving the American Dream, from CNNMoney.com

The Dow pops into uncharted 14,000-point territory. An economy pummeled by the 9/11 terrorist attacks has grown for 22 quarters straight. Unemployment stands at 4.5 percent - lower than any average decade from the 1960s through the 1990s. And Treasury Secretary Hank Paulson declares: "This is far and away the strongest global economy I've seen in my business lifetime."
So why do six out of ten Americans think that the economy was better five years ago and fear that worse economic times are on the horizon, according to the latest USA Today/Gallup poll? "If it makes you happy," moans Sheryl Crow, "then why the hell are you so sad?"


This isn't new, but it is befuddling. The public has been blue about the economy for years, giving rise to an industry of blame-layers. Liberals predictably blame George Bush - for the war, for tax policies that favor the rich, for letting U.S. jobs go to China and India. Conservatives point the finger at the "liberal media establishment," which, they insist, put a shinier spin on the Bill Clinton bubble economy than on George Bush's recovery. And when all those explanations are exhausted, pundits like to blame Americans themselves - for being spoiled and soft and wanting too much.

But as new directions for the nation are being debated on the '08 presidential candidate trail, the question deserves a more thoughtful answer.


Democratic pollster Celinda Lake took a stab at it with a series of surveys that found only 18 percent of Americans believed they have obtained the "American dream." In a presentation last week at the Brookings Institution, she blamed concern over "the basics - health care, retirement, personal debt, paying the bills." She added: "People believe that corporations and wealthy interests have too much power and that they are putting up barriers...to working people achieving the American dream."

While there may be some truth in this, it's a brand of class consciousness that hasn't exactly connected with voters in the past (though John Edwards is taking it out for a spin once again). As Jim Kessler, vice president for policy at the two-year-old think-tank Third Way, put it: From Walter Mondale and Michael Dukakis to Al Gore and John Kerry, Democrats "not only lost, but they lost to the middle class." Last year, in the 2006 congressional elections, Democrats won among middle-income voters for the first time since 1990.

As Third Way documents in its reports, the American middle class isn't really shrinking, so much as it is anxious. The median household income for workers aged 25 to 60 is nearly $62,000. If both spouses work, it's close to $82,000. As Kessler notes: "That is not an extravagant living. But it is not drowning. And it is not one step away from losing your home." The same Third Way report noted: "The bottom line is that the middle class is shrinking not because the bottom is dropping out; it is because more people are better off."

So why the jitters?

Lake hit on it, I believe, with this comment: "There have been times in our history when the American dream was rooted in opportunity, and there have been times in our history where the dream was rooted in security. This is a time, and has been for a couple for years now, where the dream is rooted in security."

There's not a lot of security in a fast-paced global economy where workers get ahead by chasing opportunities (not obediently following office rules), by constantly reinventing their careers (not relying on seniority), by self-investing their savings (not counting on company pensions).

In other words, in the new economy, we all have to be entrepreneurs with our own lives - with all the rewards and risks and, yes, anxieties that entails. According to Third Way, middle-aged men are staying at the same job nearly half as long as they were just 20 years ago, and more than 60 percent of workers report they've actually had to switch the type of work they are doing.

Add to all that a war in Iraq that America can't seem to win, and the always looming threat of another terrorist attack here at home, and it goes a long way toward explaining public unease.
The presidential candidates are already talking about building a stronger safety net for workers. But before buying into more calls for government spending, we should be debating what a 21st century safety net should look like.


As Rep. Jim McCrery, ranking Republican on the House Ways and Means Committee, notes: "We need to do something different. The old safety net we have in place is built for a time when people went to work for a company and stayed 30, 35 years, and then retired on a pension with defined benefits. The world has changed and we ought to look at new approaches to give workers in this country some feeling of security." And that's a conversation that doesn't have to rely on the same old partisan blame game.

Credit Market Fall-Out #8 – Still More Bad News Ahead

With about $0.5T (that is T as in trillion) loans to reset there is still plenty of indigestion to go around according to MSNBC. Also Mr. Lo from MIT admits in the article that that there are still some hedge fund, dealer, and bank casualties ahead of us. This is one of the first times I have seen that mentioned in the financial press. I personally expect there to be several “big name” casualties in this process.

The stricken US subprime mortgage market is likely to suffer further setbacks in the coming months as $500bn of risky home loans sold with initial low "teaser" interest rates are reset at much higher levels, analysts warn.

Over the next 18 months, adjustable-rate home loans sold at the peak of the high-risk lending boom in 2005 and 2006 will be reset. Given a recent tightening of lending standards as banks try to rein in their mortgage exposures, this raises the prospect of further serious losses. Christopher Flanagan, strategist at JPMorgan, estimates up to 45 per cent of borrowers facing resets will not meet criteria to refinance into new home loans.

The mounting problems could force ratings agencies to downgrade billions of dollars of mortgage securities below investment grade, a move that would in turn force many investors to sell their holdings and exacerbate the spiral of losses.

Ratings agency downgrades of subprime-related securities have already gained momentum in recent weeks, helping to push a key derivatives index tracking such securities to record lows. The ABX index tracking 2006-issued subprime bonds rated BBB- fell to a record low of 41 cents on the dollar on Friday, down more than 50 per cent since January.

"There is a possibility that one or two money centre banks and dealers could be a casualty along with hedge funds and institutional investors," said Mr Lo. Even higher-rated securities were unlikely to be immune from losses, Mr Flanagan said. "Losses are going to move up the capital structure to the higher-rated pieces. Hedge funds will continue to feel the pain," he said. (my emphasis)

Credit Market Fall-Out #7 – Bear Stearns and Barclays

An issue that I posted about a few days ago concerned all the firms that lost money by investing in the Bear Stearns hedge funds that currently have no value and what they were going to do. Well, it did not take long for the issue to arise, from Market Watch.

Barclays Plc, once an investor in a now worthless Bear Stearns hedge fund that bet on subprime securities, is now considering its options for recovering $400 million it invested in the fund, the Wall Street Journal reported in its online edition on Saturday.

Barclays was an investor in the Bear Stearns Asset Management's High-Grade Structured Credit Strategies Enhanced Leverage Fund, which put billions of dollars in the subprime-mortgage market, the Journal reported.

Barclays lent the fund about $200 million and later offered an additional $250 million, the Journal reported. The $200 million loan has been paid off, while the $250 million was never extended, the Journal said.

However, Barclays is now considering its options for recovering $400 million that it invested in the fund separately from the loan . . . . The possibilities are a negotiated settlement or litigation.
(my emphasis)

Bear Stearns said earlier this week that two of its hedge funds that made big bets on subprime securities are worth virtually nothing.

The High-Grade Structured Credit Strategies Enhanced Leveraged Fund, in which Barclays invested, is worth nothing, while there is "very little value" left for investors in the larger, less leveraged High-Grade Structured Credit Strategies Fund, based on estimates at the end of June, according to a letter the investment bank sent to clients.

Friday, July 20, 2007

Ben Bernanke is a Little More Candid About the Housing Market

At least the extent of the damage in the housing market is beginning to come out, from Market Watch.

Federal Reserve Chairman Ben Bernanke said Thursday that there will be "significant losses" associated with subprime mortgages but that these losses should be regarded as "bumps" along the road of market innovation.

Bernanke's second day of testimony before Congress on the state of the nation's economy and the outlook for U.S. monetary policy was dominated by concern about the subprime-mortgage sector.

Bernanke said these were "market innovations" and "sometimes there are bumps" in the new-product road.


"We'll see how this works out," Bernanke said.

The Fed chief repeated that the problems in the subprime-mortgage market haven't caused a systemwide credit crunch.
In addition, Bernanke told members of the Senate Banking Committee that the pain and suffering felt from foreclosures and delinquencies will "likely get worse before they get better."

Bernanke, under fire from lawmakers for the Fed's failure to step in earlier to address the factors underlying the nation's housing bubble, said the Fed and other regulators will soon issue stronger rules to protect consumers.

Bernanke said there were going to be "significant losses" in subprime-mortgage paper, citing estimates ranging from $50 billion to $100 billion.
(my emphasis)

June CPI Relatively Tame

One month does not make a trend, but the CPI numbers were relatively tame for June. The article can be found at Market Watch and the original government press release can be found at the BLS.

U.S. consumer prices increased a moderate 0.2% in June, with falling energy prices offsetting rising food prices, the Labor Department said Wednesday. It's the smallest increase in the seasonally adjusted consumer price index since January.

Excluding volatile food and energy prices, the core consumer price index also increased 0.2%, the government said. Consumer prices are up 2.7% in the past 12 months; core inflation is up 2.2%. In May, the CPI rose 0.7% while the core CPI was up just 0.1%.

Energy prices fell 0.5% in June after surging the previous three months at an annual rate of more than 70%. In June, gasoline prices fell 1.1% and natural gas prices fell 0.1%. Gasoline prices have inched higher in recent weeks, however.

Food prices are up at an annual rate of 5.1% in the past three months, driven higher by adverse weather, strong global demand and the diversion of much of the corn crop and the nation's arable land into the production of ethanol for fuel.

Outside of food prices, inflation was generally tame in June. Medical care prices rose 0.2%, housing prices rose 0.3% and apparel prices fell 0.6%.

The Fed monitors a different, but related inflation measure produced by the Commerce Department, known as the personal consumption expenditure price index, which will be released at the end of the month. The core PCE price index has risen 1.9% in the past year, just inside the Fed's unofficial comfort zone of 1% to 2%.

Wednesday, July 18, 2007

Housing Index for New Home Sales Drops to Lowest Level Since 1991

The new home sales index dropped for the 5th straight month and is now at its lowest level since 1991, from Yahoo. Market Watch also has a good analysis of the index.

Personally, it is about time that people begin catching on to the conditions in the housing market. Let's face facts, there is a significant adjustment taking place in the housing market now. Inventories are up, sales are down, loan criteria are tougher, the consumer is waiting on the sidelines for prices to decline more, and rates are higher. The housing/builder market has to adjust to the new realities or they will continue to get the more of what they already have - limited sales. I realize this is easier said then done, but business is about making a profit and if you can't ride through the trough you don't get to make a profit when the market turns up. So it is all about making it through the trough. One of the ways you do this is by admitting where you are really at.

A key measure of industry sentiment on the U.S. market for new homes fell to its lowest point in more than 16 years, a trade group said Tuesday, as builders struggled with rising inventories of unsold houses across the country.

The National Association of Home Builders/Wells Fargo housing market index, which tracks builders' perceptions of current market conditions and expectations for home sales over the next six months, fell to 24 this month, the lowest reading since January 1991, the NAHB said.

The index is based on a survey of residential developers nationwide. It was the fifth straight monthly decline.

Index ratings higher than 50 indicate positive sentiment about the market. The seasonally adjusted index has been below 50 since May 2006.

"The single-family housing market is still in a correction process following the historic and unsustainable highs of the 2003-2005 period," David Seiders, the group's chief economist, said in an e-mailed statement.

Seiders said he expects sales to rebound by year-end (my emphasis) and new home construction to start recovering by early next year.

Oh really! How is this going to happen? The last large housing slump started in the early 1990s and lasted better than 8 years.

Credit Market Fallout #6 - Bear Stearns and What is Next

From Bloomberg, it now appears official the two Bear Stearn mortgage related funds that failed in June appear to have basically no value. The question is what will happen next in the market. Also what about those hedge funds that invested in Bear Stearns funds? How will they fare? They still need to face their investors.


Bear Stearns Cos. told investors in its two failed hedge funds that they will get little if any money back after `unprecedented declines'' in the value of AAA rated securities used to bet on subprime mortgages.

Estimates show there is ``effectively no value left'' in the High-Grade Structured Credit Strategies Enhanced Leverage Fund and ``very little value left'' in the High-Grade Structured Credit Strategies Fund, Bear Stearns said in a two-page letter. The second fund still has ``sufficient assets'' to cover the $1.4 billion it owes Bear Stearns, according to the letter, which was obtained yesterday by Bloomberg News from a person involved in the matter.

``This is a watershed,'' said Sean Egan, managing director of Egan-Jones Ratings Co. in Haverford, Pennsylvania. ``A leading player, which has honed a reputation as a sage investor in mortgage securities, has faltered. It begs the question of how other market participants have fared.''

Bear Stearns provided the second fund with $1.6 billion of emergency funding last month in the biggest hedge fund bailout since the collapse of Long-Term Capital Management LP in 1998. The losses investors now face underscore the severity of the shakeout in the market for collateralized debt obligations, or CDOs, investment vehicles that repackage bonds, loans, derivatives and other CDOs into new securities.

``That has implications for credit weakness in the next several days and weeks,'' said Peter Plaut, an analyst at New York-based hedge fund Sanno Point Capital Management. ``There's going to be more risk aversion.''


Tuesday, July 17, 2007

The PPI is Down for June, But the Core Rate is Up Due to Higher Car and Truck Prices

The PPi is not a key number for the Fed, but it does give a feel for how the intermediate prices are doing, from Market Watch. Also the BLS press release is available so you can get it straight from the horse's mouth.

Wholesale prices fell 0.2% in June as food and energy prices declined after four months of hefty increases, the Labor Department reported Tuesday.

The PPI is up 3.3% in the past 12 months.

Food prices sank 0.8%, the second straight decline. . . . .Energy prices fell 1.1% as gasoline prices dropped 3.9%. Natural gas prices rose 2.6%.

Excluding volatile food and energy prices, the core PPI rose 0.3%, a tenth higher than the 0.2% gain expected. It's the biggest gain since February.

The larger-than-expected gain in core prices was largely due to large increases in car and truck prices, which rose more than 1%. Prices of capital equipment rose 0.3%. Prices of consumer goods fell 0.4%.

One key indicator of inflationary pressures fell to a three-year low. The core intermediate goods PPI rose 0.4% in June and was up just 2.8% in the past year, the smallest gain since February 2004.

The PPI is not the Fed's focus; the real issue is what consumer prices do. The PPI measures prices in the production pipeline, not at the retail level

The core PCE price index has now risen less than 2% in the past 12 months, within the Fed's unofficial "comfort zone." But the Fed has said that no "sustainable" moderation in inflation has been convincingly demonstrated, a clear signal that the Fed wants inflation not just to fall but to stay low.

Monday, July 16, 2007

It Is Not Necessarily Peak Oil – It Is That Demand is Outstripping Supply

After all the debate about Peak Oil, the real culprit in the oil and gas chain is that supply without declining can’t keep up with demand. Admittedly, net effect is the same, but the issue of Peak Oil which is about the supply and ultimate decline in oil production is not the deciding issue. It appears that world oil production of 85 mb/d (million barrels per day) will not handle the demand going forward, from the WSJ. Below is part of the article, but the entire article is worth a read.

Once again I realize that the current unraveling of the real estate market is more interesting, but issues like oil supply will probably effect everyone's life more than the on-going state of the real estate market. The Peak Oil issues have been discussed in a previous post, but now the issue is different. It is demand that is the issue not necessarily supply. Is this part of the Super Cycle issue discussed a few days ago here?

World oil and gas supplies from conventional sources are unlikely to keep up with rising global demand over the next 25 years, the U.S. petroleum industry says in a draft report of a study commissioned by the government.

In the draft report, oil-industry leaders acknowledge the world will need to develop all the supplemental sources of energy it can -- ranging from biofuels to nuclear power to oil extracted by unconventional means from the oil sands of Canada -- to meet soaring demand. The surge in demand is expected to arise from rapid economic growth in such fast-developing countries as China and India, as well as mounting consumption in the U.S., the world's biggest energy market.
The findings suggest that, far from being temporary, high energy prices are likely for decades to come.


"It is a hard truth that the global supply of oil and natural gas from the conventional sources relied upon historically is unlikely to meet projected 50% to 60% growth in demand over the next 25 years," says the draft report, titled "Facing the Hard Truths About Energy."

"In geoeconomic terms, the biggest impact will come from increasing demand for oil and natural gas from developing countries," said the draft report, a copy of which was reviewed by The Wall Street Journal. "This demand may outpace timely development of new supply sources, thereby pressuring prices to rise."

The study, which was requested by U.S. Energy Secretary Samuel Bodman in October 2005, was conducted by the National Petroleum Council, an industry group that advises the secretary.
The conclusions appear to be the first explicit concession by the petroleum industry that it alone can't meet burgeoning global demand for oil, which may rise to as much as 120 million barrels a day by 2030 from about 84 million barrels a day currently, according to some projections. . . . .


These conclusions follow hard on the heels of a medium-term outlook by the Paris-based International Energy Agency this month, which suggested a supply squeeze will hit by 2012. The fact that the American petroleum industry is warning of a crunch could have an even greater impact on the debate over energy policy.

Food Prices are Rising Worldwide Causing Inflation Problems

Excerpts below from the Bloomberg article comes at a very opportune time as many are debating the value of the Fed using the core inflation rate to set monetary policy. As stated before in previous posts the use of core inflation can give a distorted picture of how the economy is performing. Also I realize it is more fun (and topical) to discuss the real estate market and the credit markets, but inflation is a much more insidious problem. Having witnessed the high inflation rates of the 1970s and early 1980s first hand, inflation issues are far more important to the long term health of the economy than the unraveling real estate market. Lastly, this article ties in well with this Weekend's Contemplation.

The fastest increase in food-commodity prices in at least a decade has already led monetary authorities in England, Mexico, Chile and South Africa to lift borrowing costs. It is also sowing doubts about the U.S. Federal Reserve's focus on core inflation, which excludes food and energy, and about China's gradual approach to tightening credit.

As Fed Chairman Ben S. Bernanke prepares to deliver his semiannual report to Congress this week, central-bank officials worldwide are anxious that climbing costs may trigger consumer concerns about faster inflation. To keep them from being self- fulfilling, some of the biggest economies might have to push interest rates higher.

An unprecedented surge in global demand is behind the 23 percent rise in food prices that the International Monetary Fund recorded during the last 18 months. ``We haven't seen anything on this scale before,'' says Martin von Lampe, an agricultural economist in Paris at the Organization for Economic Cooperation and Development.

The demand, triggered in part by the increasing use of agricultural commodities to make ethanol and other substitutes for crude oil, may keep prices high for years. The OECD sees U.S. output of corn-based ethanol and European consumption of oilseeds for biofuels doubling by 2016.
Chinese and Brazilian production of ethanol will expand even faster, it said in a July 4 report with the United Nations' Food and Agriculture Organization.


Rising prosperity in China and other emerging nations is also spurring demand, particularly for value-added items such as meat and dairy products, the report said.

``We are sitting on structural changes that will affect agricultural prices for a long time to come,'' Paul Polman, chief financial officer of Vevey, Switzerland-based Nestle SA, the world's largest food company, said last month.

With prices of many everyday items starting to rise, the danger is that consumers and companies will become more pessimistic about the outlook for inflation.

``Nothing affects consumer inflation expectations more than food,'' says Richard Yamarone, chief economist at Argus Research in New York. ``Not everybody has to drive to work, but everybody wakes up and has breakfast.''

Bernanke has repeatedly highlighted the importance of those attitudes in carrying out monetary policy. ``The state of inflation expectations greatly influences actual inflation,'' he said in a July 10 speech in Cambridge, Massachusetts.

Sunday, July 15, 2007

This Weekend’s Contemplation - Inflation, Currency, and the Price of Gold

The article in the WSJ about inflation, currency and the part that the price of gold plays is worth the time to read. Below are a few excerpts:

Interest rates are on the rise in the Eurozone, Great Britain and Japan, as well as in India and China. But the Federal Reserve has again elected to keep its target rate on hold despite repeated assertions that inflation risk is still its predominant concern. Are central banks abroad recognizing a threat that their American counterpart has yet to acknowledge?

The Fed seems to believe that inflation has something to do with "excessive" demand. Although it admits that inflation is already running at an unacceptable pace, the majority of its policy officials cling to the belief (or hope) that the U.S. economy is slowing down, alleviating the inflation threat. Both of these assumptions are inconsistent with historical evidence.

What's more, the recent rise in the euro and sterling relative to the dollar has obscured the fact that the world economy has embarked on another classic "run" on paper currencies that is driving inflation up everywhere. For several years now, as was the case in the 1970s, all the world's currencies have been depreciating relative to stable benchmarks such as gold. Since the end of 2001, these declines have ranged from 38% (in the case of the euro) to nearly 60% (in the case of the dollar).

Why then has the pace of consumer-price inflation to date been so much less noteworthy than the pace of currency depreciation against gold? The answer lies in the timing: Gold is a fast-moving leading indicator, whereas consumer-price indices are slow-moving indicators that lag far behind. (my emphasis) We all learned in the period between 1975 and 1985 that consumer prices do eventually catch up. It is the size of the move in the gold price, rather than in the consumer price index, that is a true and timely indicator of the magnitude of the inflation problem.

The Future of US Liquid Fuels is Canada

The article from earlier this week in the WSJ is interesting because it indicates the direction that the US is taking to handle its future needs for energy fuels (gasoline and diesel). Below are a few excerpts, but the entire article is worth a read.

The future of the U.S. oil industry arrived last year in Cushing, Okla., moving along at two miles an hour.

It was the first crude from the Albertan oil sands to reach as far south as the giant Cushing pipeline hub, one of the locations where global oil prices are set. To get there, the crude traveled through a pipeline that for decades carried oil in the opposite direction.

A month later, a second pipeline was reversed and Canadian crude reached all the way down to southeast Texas, the world's largest cluster of petrochemical plants and refineries and the traditional front door for much of the U.S.'s oil supplies.

The pipelines . . . . represents resent long-term, multibillion-dollar investments in infrastructure to enable Canadian crude to keep cars running on U.S. roads. But the shift requires billions of dollars in investment and could clash long term with efforts to curb global warming, and still won't be enough to quench the thirst for oil in the U.S., which consumes roughly one out of every four of the more than 80 million barrels produced daily around the world.

Currently, the U.S. pipeline grid is set up to import oil into the Gulf Coast. Some of that oil is sent north by pipeline or barge to refineries in the country's Midwest region. But global supplies are increasingly unreliable, . . . . Canada is a reliable exporter, free from the political turmoil that racks much of the oil-producing world.

"It's a big expansion of Canadian supplies into the U.S.," says Shirley J. Neff, president of the Association of Oil Pipe Lines. "There is no way a pipeline company will make an investment if it doesn't see a long-term supply source and a market that needs to be served over the long term." . . .

Producers are very interested in capturing more U.S. markets for Canadian crude. Although exact figures aren't compiled, the amount being spent on Canadian oil-sands development, new pipelines to bring the crude to the U.S. and to retrofit refineries is expected to top $15 billion a year through the middle of the next decade. This easily exceeds the amount being spent to build the U.S. ethanol industry, according to London-based consultant New Energy Finance.

"The people who understand the industry the best understand that long term the most substantive solution is in the oil sands," says Charles Swanson, managing partner in the Houston office of Ernst & Young. "The fundamental economics are stronger than the stuff we hear about today that is trendy and sexy," he says, referring to ethanol and other biofuels.

Saturday, July 14, 2007

CSBS to Issue New Guidance Next Week on State Level Sub-Prime Mortgage Lending

The following from Reuters indicates how quickly the regulators are moving to close the gap between existing regulations and the “new” lending infrastructure. Some may argue that it is too late, but better late than never.

U.S. state officials plan to issue guidance next week to tighten subprime mortgage lending by brokers and originators not regulated by the federal government, the Conference of State Bank Supervisors said on Friday.

Officials at CSBS, a group representing state regulators, said so far about 27 states and the District of Colombia plan to adopt the guidance within 48 hours after it is issued on Tuesday. No state has indicated that it will not eventually adopt it, they said.

Last month federal banking regulatory agencies issued guidance to curtail risky practices blamed for a record level of home foreclosures, according to the state group.

The states issued the same standards as federal regulators when adopting nontraditional mortgage guidance last November. They are expected to do the same with the subprime guidance.

Many lenders relaxed underwriting standards for subprime borrowers with weak or no credit during a five-year housing boom that ended in the summer of 2005. Some of the most popular loans involved payments that were low in the beginning but spiked later on.

As the housing market turned, many subprime borrowers fell behind in their mortgage payments and a record number of borrowers faced losing their homes in the first three months of 2007. Many of the biggest subprime lenders have sought bankruptcy protection.

Many mortgages with flexible rates are expected to be adjusted this year and next.
New federal guidelines say borrowers should not be penalized for refinancing a mortgage before a low introductory rate is adjusted upward. It also said lenders must have evidence that a borrower can repay a loan.


The U.S. guidance was issued by the Federal Reserve, Office of the Comptroller of the Currency, Office of Thrift Supervision, Federal Deposit Insurance Corp. and the National Credit Union Administration.

Guidance for state-licensed institutions will be issued jointly by CSBS, the American Association of Residential Mortgage Regulators and the National Association of Consumer Credit Administrators.State regulators also plan to issue examination guidance for state supervisors to evaluate compliance by state-licensed mortgage lenders, including compliance on lending to subprime borrowers.

Another Perspective on CDOs

This short article from the WSJ gives a different perspective on CDOs and suggests that everyone knew what was going on and you can’t lay the blame off on the rating agencies.

When Standard & Poor's and Moody's announced plans this week to cut credit ratings on billions of dollars of collateralized-debt obligations tied to subprime mortgages, many Wall Street critics howled, "Too little, too late."

A skeptic might howl back, "Be serious." Anyone buying these debt investments, which had become increasingly popular in the past few years, should have known full well they were riskier than they appeared to be at first blush. All they had to do was look at the price.

CDOs pool debt instruments, often including mortgage-backed securities. They're then sliced into risky and less-risky pieces by Wall Street managers. Because of how CDOs are structured, with some investors agreeing to take the first losses if a CDO's holdings turn sour, the rating agencies say it's possible to load them with junky assets and still get some decent credit ratings.

Investors never completely bought into this logic. They've long demanded that CDOs offer higher returns than similarly rated bonds. One year ago, for example, investors in CDOs with an investment-grade triple-B credit rating demanded roughly two percentage points more on their investments than did investors in more plain-vanilla mortgage-backed securities with the same rating, according to J.P. Morgan data. Their demands for returns were even great when compared with similarly rated corporate debt.

Lots of investors understood what they were getting into. They demanded more return because they saw there was more risk, regardless of the ratings.

Janet Tavakoli, president of Tavakoli Structured Finance in Chicago, thinks that ratings agencies should have kept closer tabs on the tainted mortgages that went into many CDOs and that some of the models they use to come up with ratings may have been flawed. But she also believes many investors understood that the mortgages, and the securities they ended up in, carried unknown risks.

"With the amount of research that was going on and the amount of information that was available in the news, you would know the risk was unprecedented, so you demanded a premium," she says. "There are a lot of sophisticated, deep pockets here that have things to answer for, and I'm sure they're delighted to have people blaming the rating agencies."