Friday, August 31, 2007

Ben Bernanke's Speech at the Fed Meeting in Wyoming

The following link gives the full text of Ben Bernanke's speech from the Fed (includes all the references and footnotes) concerning the US housing market. The speech summarizes the current state of affairs, what the Fed is willing to do, and the history of the development of the capital markets supporting the US housing market. I did not think that the speech said anything new, but it seemed to excite the people on Wall Street.

The following paragraph was the most interesting from the speech concerning the "go-forward" perspective.

The incoming data indicate that the economy continued to expand at a moderate pace into the summer, despite the sharp correction in the housing sector. However, in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.

A Couple of Quotes to Think About on a Three-Day Weekend

The two quotes below came from a list of quotes at Financial Sense. It is worth visiting the site to go through all 25 quotes. I don't agree with all the quotes, but some of the political cartoons are pretty amusing.

The first quote is from Jim Rogers, always one of my favorite people to read about

The Federal Reserve was not founded to bail out Bear Stearns or a few hedge funds. It was founded to keep a stable currency and maintain its value. - Jim Rogers, Rogers Commodity Fund

The second quote comes from a quote (earlier post) made in the midst of the recent credit crunch

So perhaps the most worrying single remark made by a responsible banking official during the current crisis came from Jochen Sanio, the head of Germany's banking regulator BaFin. He warned on Aug. 1 that his country could be facing the worst banking crisis since 1931 -- a reference to the collapse of Austria's Kredit Anstalt, which provoked a wave of bank failures across Europe. - Martin Walker, United Press International

Still Optimistic About a Turnaround in the Housing Market in the Next Six Months?

My friends at Calculated Risk obtained a housing sales forecast from Goldman Sachs that is beginning to look a little more realistic. GS is predicting a Case-Shiller housing price index decline in 2007 and 2008 of 7% each year. Also they are forecasting a decline in sales 13% in 2007 and 15% in 2008. Too bad the forecast did not contain some type of inventory forecast as well.

One thing I was confused about was the difference between new home sales and new housing starts. It looks like starts can be twice as much as sales in some quarters.

They did not forecast out past 2008. Probably because the crystal ball starts getting pretty cloudy out that far because other factors come into play such as economic growth, income growth, interest rates, conition of the capital markets, etc. Or maybe they stopped at 2008 because there is a limit to the amount of depressing news one can take at a time.

The Bush Administration Steps Into the Sub-Prime Mortgage Mess

According to an article in at Yahoo the Bush Administration is going to ask the FHA and the IRS to help sub-prime borrowers that are close to default. This is the first action the Bush Administration has taken toward the sub-prime market.

President George W. Bush will propose reforms on Friday intended to help homeowners with subprime mortgages avoid default, his first public step to address a crisis that has created turmoil in financial markets around the world.

Bush, in a statement scheduled for 11:10 a.m. EDT in the White House Rose Garden, will discuss the need for Congress to pass Federal Housing Administration reform legislation aimed at giving the agency the flexibility to help subprime mortgage borrowers, two administration officials told Reuters.

One move will be an administrative change to allow the Federal Housing Administration to guarantee loans for borrowers at least 90 days behind in mortgage payments to help them avoid foreclosure, the Wall Street Journal reported from a briefing given to a few newspapers.

The Federal Housing Administration was founded in the 1930s Depression years after the U.S. banking system failed and millions of Americans were made homeless. Now its mission is to foster home ownership by insuring mortgage loans, especially for poorer Americans who face difficulty meeting terms for conventional loans.

Bush will urge the Democratic-led Congress to work with him in a bipartisan way to reform the tax code to help troubled borrowers revise their loans, administration officials said.

Specifically, at the present if someone loses their house in foreclosure and the debt is forgiven, the debt must be recognized as ordinary income. The Bush Administration would like this waived temporarily.

Thursday, August 30, 2007

How Have the Credit Markets Fared Since August 17?

The excerpts below are from the daily article done by Northern Trust concerning various economic issues. This article discusses on the credit markets have fared since the August 17 intervention by various central banks. The article indicates that the markets are better, but not back to what they were before the intervention. The original article gives a very readable summary of the markets with some excellent charts. Also the site is worth looking over every day, their commentary is usually very good and always rational.

It is the ninth market day since the Fed cut the discount rate on August 17 to stabilize financial markets. The effective federal funds rate is trading very close to the target rate of 5.25%

Other market spreads indicate a noticeably less persuasive picture of stability in financial markets. The spread between 3-month Eurodollars and 3-month U. S. Treasury bill narrowed to 107 basis points on August 27 from a recent high of 195 basis points on August 22, but the spread as of this writing has widened to 166 basis points. . . . . .

Is Ben Bernanke Different From Alan Greenspan? – You be the Judge

Excerpts below from a WSJ article discuss the possible differences between Ben Bernanke and Alan Greenspan. The original online article is also interesting because you get to vote for whom you think is better.


When Ben Bernanke was nominated to head the Federal Reserve in 2005, he promised to "maintain continuity with the policies and policy strategies established during the Greenspan years." But in handling his first financial crisis, Mr. Bernanke shows signs of a break with Alan Greenspan, the Fed's chairman from 1987 to 2006.

That shift is important in understanding why Mr. Bernanke hasn't cut the Fed's main interest rate yet, and it could alter investors' expectations of how the Bernanke Fed will function.
The Fed historically has had two major economic duties. Maintaining financial stability is one. Controlling inflation while preventing recession is the other.


To Mr. Greenspan, market confidence and the economy's growth prospects were so intertwined as to make the Fed's two duties almost inseparable. He cut rates after the 1987 stock-market crash and the near-collapse of hedge fund Long-Term Capital Management in 1998 to prevent investor reluctance to take risks from undermining the nation's economic growth.

By contrast, Mr. Bernanke distinguishes between the central bank's two functions. So, on Aug. 17, the Fed cut the interest rate and lengthened the term on loans to banks from its little-used discount window in hopes banks would use the window -- or at least the knowledge it was available -- to lend to solid borrowers having trouble getting credit amidst the market turmoil. The action was aimed at restoring the normal functioning of disrupted credit markets, not primarily at boosting growth.

The Fed, meanwhile, hasn't cut the far more economically important federal-funds rate, charged on loans between banks, which is the benchmark for all short-term U.S. borrowing costs.
To be sure, all central bankers see a link between financial and economic stability. Falling prices for assets like stocks, bonds and homes and tighter credit conditions can damp spending and investment. . . . .


. . . . . Mr. Bernanke's approach to the credit crunch is, in part, an effort to undo perceptions fostered by Mr. Greenspan's rate-cutting interventions. Though successful, they drew allegations of "moral hazard" -- that is, of encouraging investors to act more recklessly because they think the Fed will protect them.

Neither Mr. Bernanke nor his closest colleagues, some of whom served under Mr. Greenspan, believe there ever was a "Greenspan put," a reference to a contract that protects an investor from loss.

Yet officials acknowledge the perception that the Fed has bailed out investors in the past. When the stock market crashed in 1987, Mr. Greenspan, then on the job for just two months, used aggressive open-market operations -- buying and selling government securities -- to pump banks full of cash, which caused the federal-funds rate to fall to about 6.75% from 7.25%. His priority was to keep banks well supplied with cash so that strapped securities dealers wouldn't fail for lack of financing.

"We shouldn't really focus on longer-term policy questions until we get beyond this immediate period of chaos," transcripts record him telling colleagues the day after the crash. The Fed kept the funds rate low in ensuing months, and the economy didn't skip a beat.
In 1998, Russia's default on its debt, followed by the near-collapse of Long-Term Capital Management, caused credit markets to freeze up, much as they have recently. Mr. Greenspan's reaction illustrated how much he considered investors' attitudes toward risk as intrinsic to the economy's health.


"It would be wrong to say that the change in psychology is all ephemeral just because we have not seen it in the hard data yet," he told colleagues. "It is the change in value judgments that alters the real world." The Fed cut interest rates three times by a total of three-quarters of a percentage point that fall. The economy accelerated, and the stock market, erasing its losses, went on to more spectacular gains.

Mr. Bernanke may yet have to cut rates. But the longer he waits, the more likely he can break investors of the assumption that market convulsions lead to interest-rate cuts. There is evidence he is succeeding. On Aug. 16, with stocks plunging and debt markets in disarray, money manager Bridgewater Associates wrote in its widely read daily commentary: "Credit in the economy is shutting down, and the Fed needs to ease now."

By this past Tuesday, with markets having settled down, the same firm wrote: "If we were in the Fed's shoes, we certainly wouldn't be in a hurry to 'save the system' until there was more evidence that the system needed saving."


Wednesday, August 29, 2007

Credit Card Defaults Increase

This is an extension of the post below addressing the issue of increasing levels of credit card losses, from the WSJ. According to the article a lot of the increase is due to higher levels of bankruptcy in recent quarters. Looks like the effect of the 2005 law have already worn off.

With more Americans filing for bankruptcy again after last year's hiatus, credit-card-default rates are rising.

Though the percentage of payments being written off as uncollectible isn't as high as it was a couple years ago, the conditions are ripe for it to catch up. Bankruptcy filings keep pouring in, home prices continue to fall and energy prices remain high.

According to data from Moody's Investors Service, credit-card companies wrote off 4.58% of payments between January and May, up nearly 30% from the same period in 2006.

"In 2007, we expected an increase, as bankruptcy filings returned to more normal levels," said Jay Eisbruck, managing director in Moody's Investors Service Asset-Backed Finance Group. He called this year's resurgence in bankruptcy filings the primary reason credit-card default rates have soared.

In mid-2005, when home prices were still on the rise, the default rate was around 6%, and in 2004, it was even higher. What ended up bringing the default rate down to about 3% in late 2005 and early 2006 were changes in U.S. law that made it more expensive and more difficult for individuals to file and qualify for bankruptcy. Bankruptcy filings surged in late 2005 before the law took hold, and then dropped off.

Now, bankruptcy filings are flooding back in. According to the Administrative Office of the U.S. Courts, the nation's bankruptcy filings jumped 66% in the first quarter. That's causing default rates to soar, because getting bankruptcy protection usually means you're released of your credit-card obligations.

Part of the reason more people are filing for bankruptcy is falling home prices. When home prices depreciate, it makes it harder for many homeowners to access cash through refinancing their mortgages. Some homeowners, especially those who got stuck with high rate loans, can't make their mortgage payments.

Tuesday, August 28, 2007

Credit Market Fall-Out #24 – The Downgrading of the Banks

The excerpts below from a Market Watch article shows that the investment banks are beginning to downgrade one another. Let’s face it was going to happen sooner or later.


U.S. stock indexes tumbled more than 2 percent on Tuesday after Merrill Lynch warned that ailing credit markets will hurt bank profits, while reports showing eroding consumer confidence and falling home prices added to concerns about the economy.

Merrill Lynch downgraded Bear Stearns Cos, Lehman Brothers, and Citigroup to "neutral" from "buy" and lowered estimates for the banks' earnings due to turbulence in the debt markets, slowing takeover activity and upheaval in the mortgage sector.

Merrill's move came a day after Goldman Sachs slashed its earnings forecasts on Bear Stearns, Lehman Brothers and Morgan Stanley.

"All the brokers are downgrading each other, which was a long time coming, but obviously, the market is a little jittery surrounding anything related to that stuff these days," said Michael Church, senior portfolio manager at Church Capital Management, in Philadelphia.

Credit Card Losses in the US Up Almost 30% From Last Year

According to Market Watch credit card losses in the US are up compared to last year. Many in the financial business use credit card losses as an indicator of where consumer debt is headed. Usually higher credit card losses indicates that the consumer is having problems and losses in other debt categories could follow (i.e. auto loans, mortgages, etc.)

U.S. consumers are defaulting on credit-card payments at a significantly higher rate than last year, according to a Financial Times report citing Moody's data. Credit-card companies were forced to write off 4.58% of payments as uncollectable in the first half of 2007, almost 30% higher year-on-year, the report said. But Moody's said the rate of losses remained well below the 6.29% average seen in 2004, a year before the US enacted a new law that made filing for personal bankruptcy more onerous, the report said.

Consumer Confidence is Down in August Says the Conference Board

Excerpts below from an article from Market Watch, indicates the consumer confidence is lower in August. It appears that the consumer is losing some confidence in the near term economy. This still needs to play out a little more, but a number of the components of this index are moving in the wrong direction.

Softening economic conditions and volatility in financial markets led to a sharp decline in U.S. consumer confidence in August, the Conference Board said Tuesday.

The consumer confidence index fell to 105.0 in August from a revised 111.9 in July, which was a cyclical high, the private economic research group said.

This is the lowest level of confidence since August 2006 and the biggest drop since the aftermath of Hurricane Katrina in September 2005.

Lynn Franco, director of the Conference Board's research center, said the continued problems stemming from the woes in subprime mortgages may have played a role in the drop in confidence, but softening business and labor market conditions were also factors.

Ken Goldstein, an economist with the Conference Board, said in an interview with cable network CNBC that the index was "nowhere close to a recession right around the corner," and said consumers were showing resilience.

"This number is still above 100. If we were about to go into recession, this number would be a good 30 to 40 points lower," Goldstein said.

The number of consumers saying conditions are "good" dropped to 26.4% in August from 28.3% in July. Those claiming conditions are "bad" increased to 16.3% from 14.5%.

The assessment of the labor market was less favorable than last month. Those saying jobs are "hard to get" rose to 19.7% from 18.7% in July. (my emphasis)

The Case-Shiller Home Price Index Down in July

It looks like along with declining home sales there are continuing price declines as well. There are some quotes in the Market Watch article below that are interesting. Also the original press release from S&P has some interesting tables and graphs.


U.S. home prices fell at a faster rate in the second quarter, down 3.2% compared with the same period in 2006, Standard & Poor's reported Tuesday.

It marked the largest year-over-year decline ever recorded in the 20-year history of the Case-Shiller home price index.

A year ago, home prices were rising at a 7.5% pace nationally.

"The pullback in the U.S. residential real-estate market is showing no signs of slowing down," said Robert Shiller, chief economist at MacroMarkets LLC, which computes the price index for S&P.
In an interview with MarketWatch, Shiller noted that the figures were for activity ending in June -- well before the more recent blowup in the mortgage markets.


"This slow-burn downswing probably has a long way to go," wrote Charles Dumas, an economist for London's Lombard Street Research. "The backlog of unsold homes has reached a level at which buyers are likely to get nasty, insisting on deep price cuts. As repossessed homes come on the market over the next 18 months, downward pressure on home prices and whole neighbourhoods will intensify." (my emphasis)

"We are fast approaching the rate of price decline seen at the end of the 1990-91 recession, and the odds strongly favor blowing past this mark in coming months," wrote Joshua Shapiro, chief economist for MFR Inc. "With supply overhang growing and mortgage financing tougher to obtain, home prices are going to soften considerably further in the quarters ahead."

The last time prices fell so much, it took more than eight years for home prices to return to their peak level.


Monday, August 27, 2007

Existing Home Sales Are Down in July

Existing home sales, which comprises the lion’s share of the home sales, is down again in July according to NAR. Existing home sales are down 9.2% from July of last year. As an aside new home sales were down 10.2% from the same period last year. The disturbing number is that the inventory is up to 9.6 month supply. This will only get worse as the market moves into the slower fall and winter months, plus the next big surge of ARM re-sets occurs from October through February. It would not be surprising to see the inventory number approach 11 or 12 months.

Another thing that should be considered, but is difficult to quantify is shadow supply. Those the are people that want to sell, but have pulled their homes off the market due to market conditions. When you consider, the inventory, potential inventory from the ARM resets over the next 6 months, shadow supply, illiquidity in the mortgage markets, tougher underwriting criteria, and the effect that all of this will have on the economy it is difficult to be optimistic until 2009 at the earliest and more than likely it will be 2010 before the market bottoms out.

Total existing home sales, including single-family, townhomes, condominiums and co-ops – slipped 0.2 percent to a seasonally adjusted annual rate1 of 5.75 million units in July from an upwardly revised pace of 5.76 million in June, and are 9.0 percent below the 6.32 million-unit level in July 2006.

The national median existing-home price2 for all housing types was $228,900 in July, down 0.6 percent from July 2006 when the median was $230,200, the highest monthly price on record. The median is a typical market price where half of the homes sold for more and half sold for less.

Total housing inventory rose 5.1 percent at the end of June to 4.59 million existing homes available for sale, which represents a 9.6-month supply at the current sales pace, up from an upwardly revised 9.1-month supply in June.

Sunday, August 26, 2007

Another Move by the Fed to Work with the Big Banks

The Fed made another move this last week to work with the big banks. This move allows the banks to move more capital their the brokerage subsidiaries. The problem is, I am not sure why this is happening. Is it because the brokerage subsidiaries are having liquidity issues or is it to facilitate the movement of capital into the markets? From CNNMoney.com:

The Aug. 20 letters from the Fed to Citigroup and Bank of America state that the Fed, which regulates large parts of the U.S. financial system, has agreed to exempt both banks from rules that effectively limit the amount of lending that their federally-insured banks can do with their brokerage affiliates. The exemption, which is temporary, means, for example, that Citigroup's Citibank entity can substantially increase funding to Citigroup Global Markets, its brokerage subsidiary. Citigroup and Bank of America requested the exemptions, according to the letters, to provide liquidity to those holding mortgage loans, mortgage-backed securities, and other securities.

This unusual move by the Fed shows that the largest Wall Street firms are continuing to have problems funding operations during the current market difficulties, according to banking industry skeptics. The Fed's move appears to support the view that even the biggest brokerages have been caught off guard by the credit crunch and don't have financing to deal with the resulting dislocation in the markets. The opposing, less negative view is that the Fed has taken this step merely to increase the speed with which the funds recently borrowed at the Fed's discount window can flow through to the bond markets, where the mortgage mess has caused a drying up of liquidity. (my emphasis)

On Wednesday, Citibank and Bank of America said that they and two other banks accessed $500 million in 30-day financing at the discount window. A Citigroup spokesperson declined to comment. Bank of America dismissed the notion that Banc of America Securities is not well positioned to fund operations without help from the federally insured bank. "This is just a technicality to allow us to use our regular channels of business with funds from the Fed's discount window," says Bob Stickler, spokesperson for Bank of America. "We have no current plans to use the discount window beyond the $500 million announced earlier this week."

There is a good chance that other large banks
have been granted similar exemptions. The Federal Reserve and J.P. Morgan didn't immediately comment.

The regulations in question effectively limit a bank's funding exposure to an affiliate to 10% of the bank's capital. But the Fed has allowed Citibank and Bank of America to blow through that level. Citigroup and Bank of America are able to lend up to $25 billion apiece under this exemption, according to the Fed. If Citibank used the full amount, "that represents about 30% of Citibank's total regulatory capital, which is no small exemption," says Charlie Peabody, banks analyst at Portales Partners.

The Fed says that it made the exemption in the public interest, because it allows Citibank to get liquidity to the brokerage in "the most rapid and cost-effective manner possible."

So, how serious is this rule-bending? Very. One of the central tenets of banking regulation is that banks with federally insured deposits should never be over-exposed to brokerage subsidiaries; indeed, for decades financial institutions were legally required to keep the two units completely separate. This move by the Fed eats away at the principle.

Sure, the temporary nature of the move makes it look slightly less serious, but the Fed didn't give a date in the letter for when this exemption will end. In addition, the sheer size of the potential lending capacity at Citigroup and Bank of America - $25 billion each - is a cause for unease.

Indeed, this move to exempt Citigroup casts a whole new light on the discount window borrowing that was revealed earlier this week. At the time, the gloss put on the discount window advances was that they were orderly and almost symbolic in nature. But if that were the case, why the need to use these exemptions to rush the funds to the brokerages?

Expect the discount window borrowings to become a key part of the Fed's recovery strategy for the financial system. The Fed's exemption will almost certainly force its regulatory arm to sharpen its oversight of banks' balance sheets, which means banks will almost certainly have to mark down asset values to appropriate levels a lot faster now. That's because there is no way that the Fed is going to allow easier funding to lead to a further propping up of asset prices.

Don't forget: The Federal Reserve is in crisis management at the moment. However, it doesn't want to show any signs of panic. That means no rushed cuts in interest rates. It also means that it wants banks to quickly take the big charges that will inevitably come from holding toxic debt securities. And it will do all it can behind the scenes to work with the banks to help them get through this upheaval. But waiving one of the most important banking regulations can only add nervousness to the market. And that's what the Fed did Monday in these disturbing letters to the nation's two largest banks. (my emphasis)


Saturday, August 25, 2007

Problems in the Credit and Stock Markets Are Not Over Yet

The article below from the Financial Post (Canada) gives another perspective on the markets. I prefer the views from outside the US, they tend to be less inclined to see the world through rose colored glasses.

Stock and bond markets regained a modicum of stability yesterday, but ongoing gyrations in the commercial-paper market indicate the U.S. subprime crisis is far from over and the risk of further financial-market contagion remains high.


Short-term U.S. government paper remains the haven of choice for rattled investors as they wait to see whether the Federal Reserve's discount rate manoeuvring and liquidity injections will be enough to prevent a seizure of the financial system or damage to the underlying U.S. economy.
Economists, who only weeks ago almost uniformly predicted the subprime-mortgage mess would remain "contained," are now all over the map with their prognostications,
(my emphasis) while interest-rate futures predict the Fed will ultimately have to ride to the rescue with cuts to its more influential target rate.

Stock markets, usually considered more flighty than the more cerebral debt markets, may hold the key to how the drama unfolds.

On the pessimistic side, Stephen King, group chief economist at HSBC in London, wrote in a note: "Should the panic exhibited over the last few days turn into revulsion, the markets may never be the same again. The implied liquidity drain might leave the financial system, and the broader economy, more vulnerable than we currently believe."

The world economy "is now at risk from financial market seizure," he added.

Debt-rating agency Moody's Investors Service Inc. is adamant, however, that the global financial system can absorb the massive deleveraging going on.

"We continue to believe that, notwithstanding possible earnings depression due to asset impairment, higher funding costs and lower business volumes, the 'core' of the system is comfortably shock resistant."

While there may be problems at the periphery -- two small German banks have already triggered a bailout -- Moody's said core financial institutions such as the largest and most sophisticated U.S. and international financial firms have a "pretty high" pain threshold, higher even than in 1998 when the system was also under stress.

Still, it is clear that financial institutions all over the globe are now scrambling to off-load tainted debt. Yields on three-month U.S. T-bills tumbled more on Monday than on Black Monday in October, 1987, as investors fled money-market funds that may have exposure to debt linked to subprime loans or asset-backed commercial paper.

In the United States, half the US$1-trillion asset-backed commercial-paper market comes due in the next 60 days and buyers are likely to be scarce.

Dominic Konstam, head of interest rates at Credit Suisse First Boston in New York, said parts of the debt market are already constricting. "Illiquidity is showing up everywhere, even in the rates market, the swaps market, he repo market is going ballistic," he said.

Banks are getting unwanted collateral on their balance sheets. "Either because a [commercial paper] program fails or because there's a hedge-fund margin call and hedge funds are liquidating positions or ... because they've got a pipeline of corporate loans they can't get rid of because they can't collateralize them anymore, so they're having to finance these assets."

To ease the constraints, the Fed cut the rate it charges to banks to borrow to 5.75% from 6.25% on Friday. But interest-rate futures are still expecting it to cut the rate banks charge each other by at least 25 basis points on Sept. 18., or even sooner.

However, Mr. Konstam said the Fed will hold out as long as possible to see if its liquidity moves work.

"At the end of the day, you're probably not going to see that much borrowing going on [at the discount window] and that means that for all the panic and screaming out of Wall Street, banks are finding ways of financing themselves without too much stress, without sort of wholesale liquidation of these assets at rock-bottom prices."

Companies, which have had robust profits, have not really had to borrow much this cycle, except to fund their takeover binges, he said. It is only when they start having trouble finding funding to build a factory or expand a plant that the liquidity crisis turns into a crunch, which could hurt the underlying economy.

With debt markets now wrapped in a blanket of fear, it is share prices that are probably now in a better position to sniff out whether this is happening. If they start to seriously crumble again, the Fed will likely move forward with a cut to the fed funds target, moral hazard be damned.


Gold #12 – The Part That Gold Has Played in Past Crisis and the Gold Market Today

Excerpts below from a Market Watch article discuss gold prices in past financial crisis and how the gold market is different today than from times past.

As frustrating and unpredictable as gold has been in the past few years, it parallels history at times -- and sometimes it's anyone's guess. Analysts blame that on the metal's changing market.


"The entrée of large institutional players have most definitely altered the gold landscape to the point where it is no longer the same old game," said Jon Nadler, a senior analyst at Kitco Bullion Dealers. "This new reality has infused additional volatility and counter-intuitive trading patterns into the gold market equation," he said.

So in short, you can learn a lot about gold and where it may go by comparing it to what it's done before in similar situations but in the end, you may end up without a clue.

Take some of the market crashes of the past for example.

"There are certainly some parallels that can be drawn with 1987, 1929 and the 1970s," said Mark O'Byrne, director of GoldandSilverInvestments.com.

He stressed the word "parallels" and insisted that no one can actually "compare any one previous market crisis or crash as they are all so different."

And as investors "tread through the ongoing credit crisis," gold will likely act very differently than it has during past stock market corrections or crashes, said David Beahm, vice president of marketing and economic research at Blanchard.

It's difficult to know how this crisis will evolve; there are so many variables, said O'Byrne. And how the U.S. government and the Federal Reserve responds to the situation will largely "dictate whether a coming recession is deflationary, hyperinflationary or a virulent strain of stagflation."
"Gold would perform differently in each type of recession," O'Byrne explained. Gold would be the "asset class to own in a hyperinflationary or severe stagflationary scenario as it was in the brutal hyperinflation in Germany in the 1920s and in the stagflationary U.S. in the 1970s," he said.
In a deflationary scenario, gold prices might fall along with stocks and property, but fall by "far less" than other asset classes, he said.


In that scenario, a "combination of gold, but also cash, treasuries and conservative, fiscally prudent government bonds would be where investors should protect their wealth," he said.

Nadler said that while gold has historically fallen along with the value of other assets during times of deflationary crises, it's usually been in the initial stages.

"This time around, things may be different, insofar as both such a decline as well as any subsequent recovery may well be intensified by the presence of institutional players in the marketplace," he said.

"The gold market is much broader than in the past, and [most importantly] there are new players in the equation [hedge funds for one] whose trading motivation and patterns may not only go counter to the intuition and behavior of individual investors, but who have shown a predilection for treating gold as simply another asset without regard to its historical attributes," Nadler said.

A study of past recessionary periods will help traders come to some sort of conclusion or prediction on the gold market, but that should only be a reference point because so much of gold's market has changed.

Ned Schmidt, editor of the Value View Gold Report, points out that up and into the 1930s, central banks "hoarded" gold and private ownership was banned. That situation doesn't exist today.


And in 1929, gold was backed by the dollar (I thought the dollar was backed by gold?) and "thus did not fluctuate in price," said O'Byrne. "When stocks lost 90% of their value, gold was money and retained its value 100%."

Gold was then revalued to $35 from $22, or by some 60%, in 1933, he said. So "even in a massive deflationary event, gold massively outperformed all asset classes and performed its safe-haven role."


During the stock market crash in 1987, the price of gold reacted positively -- at first, then it gave back its gains and more, according to Beahm.

The main difference between then and now, however, was gold's inability to move freely, he said.
In 1987, major gold producers were or were starting to use forward selling, or hedging, to their advantage. "This prohibited gold from moving freely and behaving as a safe haven for investors long term," he said. Now these producers are closing their hedge books.


"De-hedging reached a record high in the second quarter [of 2007] as a wave of buybacks led to a provisional 5.2 million-ounce cut" from gold producers' hedge books, precious metals consultancy GFMS reported Tuesday, in a study complied for Societe Generale.

"Since major dehedging began in 2002, gold has begun to move more freely and the price of gold has increased more than 100%," said Beahm.

So what's happening now? Plenty.

Current catalysts for gold prices include: inflation, especially global inflation, geopolitical concerns, rising demand for gold, moves in the dollar and others -- in addition to the global financial crisis, said Dan Hassey, a senior research analyst for Boca Raton, Fla.-based Gold & Energy Advisor.

Some believe a lot of those factors are already in the price of gold and that's why gold has not moved much -- it's already doubled in the last five years with investors having anticipated some of these problems and bidding up the price, he said.


Even so, the seriousness of the financial situation is obvious. "A massive liquidity hole has opened in Europe as a consequence of the collapse of the U.S. mortgage market," said Ned Schmidt, editor of the Value View Gold Report. And "the pipeline for money from investors to the real economy is being ripped up."

Brien Lundin, editor of Gold Newsletter, considers the current financial situation to be a "crisis ... similar to previous pricked bubbles."

The situation is characterized by repeated liquidity crunches in which overblown markets have forced speculators to raise cash as markets either tumble or completely shut down, he said.
"Gold has been victimized by this, as it has served as a ready source of liquidity for those desperate to raise cash," he said.


The rush to liquidity and safety at a time like this first targets cash and related instruments, said Kitco's Nadler.

"If the crisis develops into a real dire event, gold ultimately benefits by either falling less in a deflation or by rising as the official sector prints its way out of trouble and creates inflation," he said.


Friday, August 24, 2007

Another Perspective on the Credit Crunch – An Insolvency Crunch

My favorite author (Ambrose Evans-Pritchard) on financial matters from the UK gives his views of where we are headed. Strangely enough, this article does not demonstrate his usual sense of humor. Maybe Ambrose is getting worried. From the Telegraph.co.uk:

The liquidity crunch is not yet over: the insolvency crunch has hardly begun.

Yes, investors are jumping back into the stock markets, hoping this is just another routine shake-out - much like February 2007, or May 2006 - before the rally resumes. The `buy-on-dips’ orthodoxy dies hard.

And yes, speculators have renewed their leveraged bets on the yen and Swiss franc carry trades, borrowing cheap in Tokyo and Zurich to play global assets. The core belief is that nothing has really changed, that the world economy is still in rude good health.

Be very careful. Interest rates in Europe and Asia are that much higher now, with delayed effects starting to bite hard. Japan’s economy has stalled to 0.1pc growth in Q2; the euro-zone has slowed to 0.3pc; and China’s refusal to import (by currency manipulation) makes it a drain on world demand. Above all, the credit bubble that perpetuated the rally of the last eighteen months beyond its natural life has definitively burst.

Credit spreads on the iTraxx Crossover (a good barometer of corporate bonds) have ballooned 180 basis points since February. The cost of borrowing for most firms in Europe and North America has jumped from circa 6.5pc to 8.3pc, if they can get it.

Many cannot. Germany’s Chamber of Industry told me yesterday that it had been flooded with distress calls from family Mittlestand firms unable to roll over credit lines. In Canada and Australia, junior mining finance has dried up almost entirely.

Global junk bond issuance has been frozen for two months. Fresh sales of collateralized debt obligations – the CDOs of subprime notoriety: a $1 trillion sold last year - have all but stopped. Banks have yet to off-load $300bn of debt from leveraged buy-out deals, forcing them to keep the liabilities on their books. They are all snake-bitten now.

The private equity buy-out premium – which pushed up the price/earnings ratio on the MSCI-600 of “median” stocks to a record high of 20 in May - has vanished. The P/E ratios on the DOW 30 big stocks are much lower – because they are too big even for the big cat predators, KKR and Carlysle – but they are not low, given the late stage of the cycle. In reality, an earnings bubble and ultra-cheap credit have flattered profits.

So no, the world has changed, dramatically. Whether this means a protracted global downturn and a “profits recession” depends on how quickly the central banks choose to respond, and how far they are willing to go.

Ben Bernanke is looking hawkish to me, given the shock of what happened on Monday when yields on 3-month US Treasury notes plunged at the fastest pace ever recorded, a panic flight to safety that no living trader had ever seen before.

Why? Because trust had collapsed to such a degree that players with a lot of cash no longer believed it safe to leave wealth in bank accounts, or the money market funds of brokerage companies - (exposed as they are to short-term commercial paper and subprime CDOs). This did not occur after 9/11, or in the heat of the October 1987 crash. Nor did was there such a banking panic in October 1929. (it hit in August 1931). If you think this is of no importance, or that this will pass swiftly, you have a strong nerve.

When you have a run on the money markets like this, it is bound to spill over into the real economy,” said Albert Edwards, global strategist at Dresdner Kleinwort. (my emphasis)

“We already thought there was a 40pc chance of a US recession before all this happened, but the risks are now much higher and don’t forget that rates on adjustable mortgages will keep rising until a peak next March, so the maximum pain will be in the second and third quarters of 2008,” he said

“There will be large bankruptcies, and liquidity is not going to help because too many people bet the farm at the top of the cycle, and they’re now insolvent. A lot more bodies are going to be floating to the surface before this is over,” he said.


The belief that Europe would somehow be insulated has been tested over the last two weeks. Two German banks have required bail-outs on subprime bets – Sachsen LB for Eu 17.3bn, IKB for Eu 8.1bn.

Alexander Stuhlmann, boss of WestLB, confessed that the German banking system was in a "not uncritical situation". Jochen Sanio, head of the German regulator BaFin, said a few days earlier that the country faced the worst banking crisis 1931. (my emphasis)

Hence the continued actions of the European Central Bank, which has quietly injected 85bn euros in extra liquidity so far this week, almost as much as it did on the first day of emergency stimulus in early August.

“Banks are still thirsty for credit, and the spreads have been amazing. This is not business as usual at all,” said Julian Callow, chief Eurozone economist for Barclays Capital and an expert in the arcane field of central bank operations. (He used to work for the Bank of England.)

To clarify: the ECB allotted an extra Eu 45bn extra through a `weekly refi’ on Tuesday; and then Eu 40bn in a 3-month offer on Wednesday to stop the short-term commercial paper market seizing up.

What we know is that 146 banks bid for loans on Wednesday, some clearly in such distress that they were willing to pay up to 5pc interest – a full 1pc above the ECB’s benchmark rate.
Just like the dotcom bust: when the US sneezes, Europe catches… you know the rest.
In a warped sense, one has to admire the cool way that Americans – who save nothing, in aggregate – tapped into the vast savings pool of thrifty Germans to finance their speculative excesses, and then left the creditors holding a chunk of the subprime losses.



With all the Problems Elsewhere, Growth in Asia Continues

It did not appear that the global credit crunch was effecting growth in Asia. Here seems to be some proof, from the WSJ:

Investors are watching every downtick in commodities prices as a potential sign that the credit crunch could torpedo global growth.

It might pay to glance at something else: the Baltic Exchange Dry Index, a lesser-known measure that is closely watched in grain and metals circles. Published by the Baltic Exchange, a ship-chartering marketplace in London for more than 250 years, the index reflects rates to transport bulk commodities such as coal, iron ore and grains in vessels from the relatively small to the gigantic.
Amid last Thursday's stock-market selloff, which also hit commodities, this index set a record. Since early August 2005, the BDI, as it is known, has more than quadrupled. Evan Smith, co-portfolio manager of U.S. Global Investors' Global Resources Fund, says the BDI's continued strength this week, just 1.1% off last week's peak, "is a good indicator that demand's not going away."


One reason the BDI has stayed high is China and other Asian countries have had to look farther away for commodities due to congestion in nearby Australia's ports. Shipping commodities from Brazil or Colombia takes vessels off the market for longer periods.

Gil Landy, a freight broker who also charters ships for agricultural cargoes for the Harrison, N.Y., commodity brokerage Pasternak, Baum & Co., also suggests watching the Baltic Exchange Panamax Index, which tracks the workhorse ships that carry grains as well as coal and metals and can navigate the Panama Canal. Panamax rates set a record on July 31 but have since fallen 3.9%.

Of course, supply and demand of ships can get out of whack and give a false indication of underlying commodity consumption. Dry-cargo rates also are high because shipyards in recent years have devoted more production capacity to oil tankers, Mr. Smith says. But Wednesday, BHP Billiton, the world's biggest miner, echoed the freight bulls when it said it didn't expect the credit squeeze to damp raw-material demand in China and India.

The Last Week at the Discount Window

The excerpts below from a WSJ article on the discount window give a few more details about the extent of the borrowing at the Fed’s Discount Window.

Loans made from the Federal Reserve's little-used discount window shot up after the Fed eased borrowing terms and invited banks to borrow last Friday, though a sizable chunk was soon repaid, new data from the Fed show.

As of Wednesday, the only significant discount loans outstanding appeared to be the $2 billion in total announced with fanfare by the nation's four largest banks that day, according to weekly discount-window data released yesterday.

The data suggest that the Fed has had some initial success in getting banks to help in calming credit conditions, but whether that cooperation will continue or grow is an open question. Officials have played down the significance of the numbers, arguing that the very availability of the discount window should be a confidence booster, whether or not banks patronize it.

Analysts were divided on the significance of the data. "From the standpoint of trying to get some real liquidity into the market...by using the discount window, that part of the operation did not succeed," said Dave Greenlaw, economist at Morgan Stanley. The only institutions that borrowed, he noted, were the ones that borrowed after being encouraged to do so by the Fed. "That's real disappointing."

However, Lou Crandall, chief economist at Wrightson-ICAP LLC, took the opposite view. "The question is whether the knowledge that the discount window is available in the event of an unexpected liquidity need made a material difference in whether banks decided" to do more lending in the credit markets. While that will never be known, he noted that most markets started to improve soon after the Fed announced the easier borrowing conditions Friday, and those improvements have continued, though gradually.

On Friday, the Fed lowered the rate on discount-window loans to 5.75% from 6.25%, and lengthened the term of those loans to as much as 30 days from one day. In a conference call, the Fed also told bankers that taking loans from the discount window would be viewed as a sign of their strength, not weakness. Such loans have traditionally carried a stigma because they were usually a last resort for struggling banks. . . . .

. . . . . All five banks said they borrowed even though they had access to ample funds at lower cost elsewhere. Most said they did so to show "leadership" and encourage other banks to answer the Fed's call.

Fed officials acknowledge the banks don't need the money but hope they will lend it to creditworthy customers facing constrained financing conditions, helping restore normal trading conditions to now-sluggish debt markets. They also argue it could take some time for banks and their customers to figure out how best to exploit the window.

Sales of New Homes Up in July

The sale of one-family new homes was up in July 2.8% from June, but still down 10.2% from June of last year, according to the US Census Bureau and Market Watch. The number of homes on the market remains at a steady 7.5 months of supply.

Although higher than expected the numbers show continued weakness in the housing market.

The Bear' View

It is always interesting to be familiar with the views that are different from your own. What is the guarantee that you are correct? Excerpts from an interview with David Tice (Prudent Bear) from the Street.com:

It's been more than 10 years since Dallas-based investment manager David Tice launched this mutual fund to hoard gold, short the market and prepare ordinary investors for the coming economic Armageddon (BEARX).

"That's really irrelevant," Tice says of the landmark. "It's just a number." Does the market's seemingly inexorable rise shake his conviction that it's going to collapse? "It's been quite a rally," he acknowledged. "But it doesn't dissuade us in our opinion. We've never been more confident."


The Dow, he predicts, will fall "at least 50%" from these levels, and he says the market is only months away from beginning a sharp decline. "I think this is a topping pattern," he says. (my emphasis)

"We think it's probably three to six months away from a significant decline." He calls the latest rally "a crack-up boom. At the tail end of credit excess it just gets crazier and crazier. It sucks people in, and it's an extremely dangerous scenario."

In all, Tice argues that the rally of the past four years is masking a long-term bear market that began in 2000 and won't end for at least another five years.

The reason? In short, Tice argues that the bull market is simply massive asset inflation caused by reckless lending and easy money. Sooner or later, he says, it will have to be worked out of the system. (my emphasis)

"Our philosophy is that this has been asset inflation, created by rampant, excess credit." He argues the global money supply has grown by 18% a year for the past four years (no wonder asset prices are booming).

"We believe in the Austrian school of economics," says Tice, referring to the late-19th-century economic theory developed by Austrian economists who emphasized usefulness to the consumer in determining the value of a product.

"If you create credit faster than GDP, you will get inflation. This has to be wrung out of the system. It's only a matter of time."

Crazy? Maybe. But anyone who looks at long-term charts must realize how utterly extraordinary, and unprecedented, the past dozen years have been. Stock market valuations, house prices, household debt, U.S. trade deficits -- they're all tied together, and they've all gone berserk.

It took the Dow Jones Industrial Average nearly 100 years to put on its first 5,000 points --- and just three to put on the second. Yes, there is plenty to make you nervous, and there are a lot of really good fund managers out there who are watching the latest boom with white knuckles and a large bottle of antacid. Tice is not alone.

He believes the canary in the coal mine will probably be the dollar. He expects the greenback to tank as international investors start to lose faith in the U.S. credit bubble. He also predicts the Federal Reserve will respond by jacking up interest rates to protect the dollar from complete collapse. That, of course, would bring the credit market to a grinding halt. We'll see.

The reason? Tice isn't just betting against the stock market overall. He's also short individual stocks, including selected homebuilders, financials and consumer discretionary stocks. Some bets, particularly in the homebuilding sector, have obviously done well recently.

Prudent Bear has also invested about 18% of its portfolio in companies mining precious metals, including gold, silver and uranium. And the prices for those have been skyrocketing. "Gold is the one asset that is not someone else's liability," Tice argues. "Gold is an asset that you can carry around in your pocket, and it's of value."

Bears of all stripes believe gold will prove a "safe haven" if and when the economic reckoning arrives. The reality is that it has proven an exceptional investment over the past five years even while they wait. Part of Tice's analysis, after all, has already proven correct. Easy money has driven up the price of all assets, including precious metals. Meanwhile, America's crazy trade deficit has been slowly undermining confidence in the dollar as the world's reserve currency.

And as the greenback has slid, alternatives, including gold, have risen.

None of this has led to a dramatic market collapse yet. Tice notes that everyone in has a vested interest in keeping the game going as long as possible. "There are no enemies of asset inflation," he says. "Washington likes it. Wall Street likes it. Consumers like it." But as the sun shines on the markets around the world, he still believes storm clouds are on their way. "I am as confident as ever that we are going to be right," Tice says, though he concedes: "Things are playing out more slowly than we thought."


Another Perspective on the Tools the Central Banks Have

The following from Bloomberg gives another perspective on the tools that the central banks have at their disposal.

As global credit markets petrify, central banks are playing ``Whac-A-Mole'' with the hammer of overnight funds to bash down short-term interest rates. At least the ridiculous claims that the subprime crisis is confined to the U.S. mortgage market have subsided.

The Federal Reserve and the European Central Bank are trapped between the devil of inflation and the deep blue sea of the global money markets. The waves that carry billions of dollars and euros between financial institutions every day have been becalmed by concern about, well, take your pick from a laundry list of worries, all of which signal fear ousting greed.

If there's one takeaway from recent events, it's the reminder that the potency of global capital can leave central banks powerless. Bank of America Corp.'s $2 billion investment in Countrywide Financial Corp., the biggest U.S. mortgage lender, may have done more to stabilize financial markets than the hundreds of billions of dollars of short-term funds supplied by the Fed and the ECB.

The ensuing dilemma is simple to enunciate, much harder to resolve. Bow to pressure at next month's policy meetings, with the Fed cutting and the ECB holding fire, and central banks risk accusations of bailing out bad lenders. Keep U.S. rates on hold and raise euro rates, and they will be charged with fiddling while securities burn.

The Fed is under the most pressure to prioritize the needs of borrowers and lenders. Rates in the futures market show traders now see just a 21 percent chance that the key rate will be left at 5.25 percent by the time the Fed's next policy meeting ends on Sept. 18, down from 92 percent a month ago.

After a slow start in responding to the surge in money- market rates earlier this month as banks hoarding capital stopped lending to each other, the U.S. central bank has shown some nifty footwork in trying to dodge the rate-cut bullet.

It started by reducing the cost of emergency funds at its discount window. That borrowing source, though, has provided a weekly average of just $52 million this year when seasonal credit to small institutions in agriculture or tourism is excluded. The most it has been tapped for in the past five years is just $785 million, though almost $12 billion was drawn down following the Sept. 11 terrorist attacks.

So on Aug. 22, the four largest U.S. banks stepped up, with Citigroup Inc., Bank of America, JPMorgan Chase & Co. and Wachovia Corp. each taking $500 million of funds at 5.75 percent, well above the 4 percent rate that the overnight Fed funds rate closed at that day.
The implied message to the smaller finance houses is that there shouldn't be any stigma attached to borrowing at the penalty rate if you need to.

You can imagine the telephone conversation with the Fed that inspired such munificence; not dissimilar from the 1998 chat that brought about the rescue of Long-Term Capital Management LP. A cynic might also wonder whether Bank of America's $2 billion vote of confidence in the U.S. mortgage market by buying preferred stock in Countrywide was similarly Fed-inspired.


All of this is evidence that the Fed will keep pulling new tricks to avoid cutting its key overnight target rate of 5.25 percent, either before or at its Sept. 18 gathering -- and will rally U.S. financial institutions to its cause, marshaling the forces of capital by reminding them that their interests in maintaining market order are 100 percent aligned.

The Fed doesn't want to be bullied into changing course; it must also be acutely aware that a policy response would stoke concern the situation is even worse than it appears -- not to mention guaranteeing that Chairman Bernanke would be known as ``Helicopter Ben'' for the rest of his career.

The ECB has a more immediate problem, though its solution is likely to be different. Although President Jean-Claude Trichet repeatedly says ``we never pre-commit'' to rate changes, he has boxed himself into a corner by presaging each of the eight increases in the current tightening cycle with the words ``strong vigilance,'' a phrase he repeated earlier this month.

Expectations are justifiably high that its key one-week rate of 4 percent will increase when policy makers next meet on Sept. 6. And the ECB, sired as it was by Germany's Bundesbank, will be even more reluctant than the Fed to be perceived as pandering to the interests of the market rather than serving the needs of the economy.

The trouble is, money-market rates are already punitively high, with the cost of borrowing euros for three months climbing to 4.78 percent today, the most expensive since May 2001 and up from just 4.23 percent a month ago.

The central bank has tried to steer that rate lower, holding a special auction of 40 billion euros ($54 billion) of 91-day funds yesterday. It also said ``the position of the governing council on its monetary policy stance was expressed by its president,'' a signal that its policy course won't be diverted.

So the ECB's likely path is to enforce a higher one-week benchmark rate next month while continuing to feed the money markets with longer-dated funds.

The modern rules for central banking are still being crafted and honed. There's no guarantee that their evolution will keep pace with the turbocharged rate of change in financial markets where the prospect of fabulous riches motivates insane levels of creativity and entrepreneurship.

The recent turbulence suggests one big change may be needed. Ignoring house values and the stock market when setting monetary policy looks increasingly unsustainable when they play such a vital role in determining the economic outlook. So when central bankers hold the equivalent of their annual picnic at Jackson Hole, Wyoming, at the end of the month, the topic of asset prices should be high on the agenda.


Thursday, August 23, 2007

Problems the Fed Faces - 20th-Century Tools in a 21st-Century Market

The excerpts below from an article in the WSJ is very interesting because it discusses the problems the tools the Fed has that were created to handle an early 20th-century economy in an early 21st-centurn environment. If you don't have a subscription to the online WSJ, try page A2 of Thursday's edition.

Think, for a moment, of bearded, bookish Ben Bernanke as the chief mechanic looking under the hood of the U.S. economy.

His problem: He's got tools designed for an early-20th-century Model T Ford to fix a 21st-century computer-controlled hybrid.

The Federal Reserve was created in 1913 and equipped to prevent and respond to banking panics. When banks need cash and can't sell their assets or borrow against them because markets are panicked, the Fed lends freely to banks with good collateral.

But the Fed chairman's challenge is that bank finances aren't today's primary problem. Banks are flush but are reluctant to lend at a time when everyone else with money is also uneasy about lending. Nonetheless, Mr. Bernanke and his monetary mechanics are stuck using 1913-era tools designed for a bank-centric financial system to repair a 2007-era market-centric financial system.

Chronicles of the Credit Crunch #3 - Perspectives on the History and Where it is Going

The following articles give different perspectives on the credit crunch and the ultimate outcome. The "game" of the credit crunch is now in progress, the question is where it will end up.

This article from UK's Independent gives a perspective from outside the US:

The debt market is what makes the financial world go round, providing credit for governments and companies to invest and individuals to buy houses, start up businesses and fund their education. The market has become more complex as investment banks dreamt up new investment products based on these loans, which investors lapped up in search of high returns.

After years of relaxed lending, the market has suddenly seized up, triggered by rising defaults by "sub-prime" US mortgage borrowers. As these defaults mounted, institutions rethought their attitude to risk and suddenly became scared of losing money. Banks became unwilling to lend to each other for fear of not getting their money back. The panic has spread to shares, and there are fears that the panic could spread from financial markets to hit the wider economy. . . . .

A recent article Reuters is interesting. Below is the conclusion, which should act as a good teaser.

If -- and I think it will happen -- the interrelationship between asset securitizers and leveraged investors, be they sophisticated hedge funds or some benighted European bank, is put on a permanently more conservative footing, many asset prices will have to fall.

The damage done to the economy by the bad loans already made and by the credit drought we face until the new model emerges will be very significant.

Wednesday, August 22, 2007

Central Banks Still Injecting Funds

Excerpts below from an article in the WSJ indicates that the central banks (ECB, the Fed, BOJ, etc.) are still injecting funds into the credit markets. But the amount is much lower than the massive amounts pumped into the markets almost two weeks ago.

The Federal Reserve injected $3.75 billion, following the $3.5 billion it put into markets Monday. The European Central Bank allotted €275 billion ($371 billion) in one-week funds, which is €46 billion more than it estimated banks need for routine business. And the Bank of Japan put 800 billion yen ($6.96 billion) into its market, following an infusion of one trillion yen Monday.

Meanwhile, Russia's central bank hurried to buoy the weakening ruble and keep money rates stable. In a rare move, Russia's central bank sold around $4.5 billion on the market yesterday to help support the ruble, traders said. It also injected 87.8 billion rubles ($3.4 billion) into the market through two one-day securities repurchase agreements.

Japan's finance minister, Koji Omi, said he had spoken by telephone with U.S. Treasury Secretary Henry Paulson as they work together closely to monitor the recent financial-market turmoil.
Among major central banks, the Bank of England has stood out for its reluctance to pump extra funds into markets. The use of the standing facility typically goes unnoticed by the broader markets. But the short-term debt market is in such disarray that even the slightest hint of more trouble could roil markets.


"The London money markets are still very tight," said David Page, U.K. economist at Investec. "The [Bank of England's] lack of intervention, especially compared with other central banks, has been to the detriment of the London market."

The euro commercial-paper market has also slowed significantly in recent days. Short-term debt investors, who typically buy the corporate IOUs without concern, have been unwilling to risk that the paper might not be renewed or paid down.

The worst hit is the asset-backed commercial-paper market, where affiliates of banks or money managers sell short-term debt to pay off investors and buy assets such as mortgage-backed securities.

To be sure, some euro commercial paper is being sold, albeit for much shorter maturity dates than usual. A normal duration date for the short-term debt is one to three months. But much of the debt that traded Monday had much shorter maturities and was increasingly expensive for the debt sellers to issue.

In the euro zone, the ECB's second-consecutive surplus weekly infusion shows euro-zone banks remain unusually hungry for cash. Still, it is less than the extra €73.5 billion the bank injected during its weekly refinancing operation last week. The bank said it is trying to mop up some of those excess funds.

Troubles with S&Ls as Well

The excerpt below from an article in the WSJ indicates that there are problems with S&Ls in terms of delinquency. This is somewhat disconcerting because S&Ls play in the prime/jumbo portion of the sandbox.

Troubled assets -- loans that were 90 days or more past due or had been repossessed -- at federally regulated savings-and-loan associations in the second quarter rose 49% from a year earlier to the highest level in 14 years, according to the Office of Thrift Supervision.

The agency also said that the number of "problem thrifts," or companies rated poorly by regulatory standards, had risen to 10, up from four in the second quarter of 2006.

Still, officials said that while the 836 regulated thrifts continue to feel stress from housing and liquidity markets, their overall health remains strong, based on earnings and capital.

The thrifts make one of every four mortgages, specializing in prime or jumbo loans. Stress in their loan portfolios suggests that more types of loans -- not just subprime mortgages -- are under pressure.

The thrift industry had $14.2 billion in troubled loans, up from $9.5 billion a year earlier, officials said. That is the highest sum since 1993, though as a percentage of total assets it is only the highest since 1997.

More on the Chronicles of the Credit Crunch

Below are a series of articles in the WSJ, that if you have the time, will give some insight into the history of the credit crunch of early August, how this crunch looks compared to 1987 and 1998, and whether or not the Fed efforts are working. By the way, if you do not have a subscription the WSJ online, these articles on the front page of the WSJ on Monday and Tuesday. Go to the library, these articles are a 30 minute read.

A bried history of the credit crunch

Some lessons from 1987 and 1998

Are all the Fed efforts working?

The Chronicles of the Credit Crunch (almost sounds like an advertisement for cereal)

Below are excerpts are from a Market Watch article that gives an abbreviated history of the credit crunch of early August.

Let's review the series of seemingly inconsistent events . . . . during what was supposed to be a quiet stretch on the summer deck.

At the beginning of the summer, when "collateralized debt obligations" and "subprime mortgages" were first introduced into the mainstream vernacular, Treasury Secretary Hank Paulson was quick to assure us that the problems were "contained."

To be fair, Mr. Paulson wasn't alone. In fact, he was in very good company. San Francisco Fed President Janet Yellen, Federal Reserve Chairman Ben Bernanke, Dallas Fed President Richard Fisher and Federal Reserve Governor Fredric Mishkin were unanimous in their assuring voices that we had nothing to fear but fear itself.

Fast forward a few months. That's when things really started getting strange.
The Federal Open Market Committee, the Fed's rate-policy panel, announced on August 7 that while "markets were volatile" and "credit conditions tightened for some households and businesses," the economy "seemed likely to expand at a moderate pace in coming quarters, paced by solid growth in unemployment and incomes and a robust global economy." . . . .

Two days after the FOMC meeting, BNP Paribas, France's largest bank, halted withdrawals from three funds because it couldn't fairly value holdings tied to the stateside subprime mess.

IKB Deutsche Bundesbank confirmed that it was holding special meetings to discuss its "financial situation."

The U.K. issued a statement that its subprime crisis might be worse than the one in the U.S.

Those concerns, on the margin, were disconcerting. But as actions speak louder than words, the sequence of events that followed offered a more telling view that strange things were afoot at the Circle-K.

The European Central Bank, in an "unprecedented response to a sudden demand for cash," injected $130 billion into the financial machination.

The U.S., Japan and Australia also stepped up to the plate with piles of dough, upping the ante to more than $300 billion.

Even Canada -- Canada! -- chimed in to "assure financial-market participants that it will provide liquidity to support the stability of the Canadian financial system and the continued functioning of the financial markets."

The next day, Countrywide Financial, the biggest U.S mortgage lender, said it faced "unprecedented disruptions" in the operations. If investors were waiting for another shoe to drop, was that it?

On Aug. 14, as the price action in the financials continued to falter, UBS, Europe's largest bank, professed that "turbulent markets may cut into profits for the rest of the year."
Santander, the large Spanish bank, offered that it had upward of $3 billion of exposure to high-risk loans in the U.S.

Australian mortgage lender Rams Home Loans Group,
citing "unprecedented disruptions in credit markets," promptly took a 20% overnight haircut.

The ECB and the U.S. continued to pump liquidity into the marketplace as concerns continued to mount.

David Walker, the U.S. comptroller general, proclaimed that the U.S government was on a "burning platform of unsustainable policies with fiscal deficits, chronic health-care underfunding" and "chilling long-term stimulations" as he mapped the parallels between modern-day society and the fall of the Roman Empire.

These are not my words. They come from a nonpartisan figure in charge of the Government Accountability Office, which is often described as the investigative arm of the U.S. Congress.

"I'm trying to sound an alarm and issue a wakeup call," he said in the midst of his 15-year term, which began during the Clinton administration. "The U.S is on a path toward an explosion of debt."

The next session, as fate would have it, was Redemption Day for funds with a 45-day advance-notice redemption window. As the smartest money on the Street, including Goldman Sachs's mighty Alpha fund, took it on the chin, investors were given a chance to leave the dance.

That dynamic, so it's said, will continue to play out in the coming month as the clock ticks and outgoing mail begins to sail.

The next day, Bill Poole, the (soon-to-be-ex-) president of the St. Louis Fed, amazingly offered that the FOMC wouldn't issue a surprise rate cut absent a "financial calamity."
As Countrywide Credit tapped its entire $11.5 billion credit line, forced liquidations found their way across a spectrum of sectors and the mainstay averages approached a 10% correction from the highs, Mr. Poole seemingly tied a bow across the box the Fed now found itself in.

True to the path of maximum frustration, and amid a 300-point decline in the Dow Jones Industrial Average, the market reversed sharply higher and closed near the flat line, catching late-to-the-game pressers leaning the wrong way. Still, the overnight session was an absolute mess, with global markets getting pummeled and tensions rising into options expiration.

And that's when the FOMC, fully aware that the structural machination of August expiration would worsen volatility, pulled the trigger and cut the discount rate, completely contradicting what it said two weeks prior.

The near-term reaction, after a few tenuous downside tries, was seemingly what the panel wanted: higher prices, albeit mutedly so.

On Monday, we learned that Deutsche Bank borrowed money from the FOMC's 5.75% discount window. While the amount wasn't disclosed, sources say that the move was orchestrated to show support for the Fed as it continued to combat the credit squeeze.

As we powered up for trading yesterday, the chief executive of WestLB, one of Germany's largest banks, warned that "foreigners were increasingly loathe to extend credit to financial institutions in Europe's largest economy, which could spark a crisis."

Those comments followed similarly strained sentiments from German lender SachsenLB, which said it required a credit line of $23.2 billion due to investments affected by the U.S subprime-mortgage crisis, and IKB Deutsche Industriebank,
which required a similar bailout.

Germany's finance minister, Peer Steinbrueck, remained optimistic in the face of the news, offering that he saw no signs of the German economy being affected and that he believed "those involved have the situation in hand."

Shortly thereafter, as the U.S market readied for trading, Mr. Paulson, ahead of his closed-door meeting with Fed Chairman Ben Bernanke and Senate Banking Committee Chairman Christopher Dodd, stepped back on stage to assure us that we were enjoying the benefit of a "strong global economy" and a "healthy financial system."

Monday, August 20, 2007

The Fed Comments on the Wealth Effect of the Housing Boom and its Aftermath

The following from Market Watch discusses a paper released by the Vice Chairman of the Fed concerning the wealth effect of the housing boom and what could happen as a result. Based on the article the paper does not say anything particularly new, but it validates what many have been thinking for some time, namely the increasing wealth effect has juiced consumer spending. Also decreasing asset values has a more sensitive effect on consumer spending then in previous periods.

Rising home prices and innovations in the financial sector are the two biggest factors in the spike in U.S. household debt and the related decline in savings, Federal Reserve Vice Chairman Donald Kohn wrote in a research paper presented Sunday.

In a paper presented to a conference held by the Reserve Bank of Australia, Kohn and a Fed economist wrote that a "wealth effect" caused by rising home prices could boost consumption, leading in turn to an increase in household debt. Expenditures for more expensive homes are another factor behind an increase in debt, wrote Kohn and co-author Karen Dynan, chief of the household and real estate finance section of the Fed's Division of Research and Statistics.

In their paper, Kohn and Dynan noted that the personal savings rate in the U.S. has fallen from an average of 9.1% in the 1980s to an average of 1.7% so far this decade. In the same period, the ratio of total household debt to aggregate personal income has risen from 0.6 to 1.0.

Meanwhile, new financial products have reduced the cost and availability of housing finance, wrote Kohn and Dynan.

"Innovation has opened up greater opportunities for households to enter the housing market and for homeowners to liquefy their housing wealth, thereby helping them smooth consumption of all goods and services," they wrote.

Kohn and Dynan wrote that there are several reasons to be cautious about the impact of rising debt levels on the overall economy, although they noted that increased access to credit should give households the ability to weather shocks.

They said household spending is now probably more sensitive to unexpected movements in asset prices than it used to be. (my emphasis) Kohn and Dynan also wrote that some households are prone to become very highly indebted relative to income and wealth.

They noted that some U.S. households will face "significant financial distress" thanks to ongoing turmoil in the subprime mortgage market and said that regulators should consider additional rules for safe and sound underwriting practices.

Later this year, in an effort to address the fallout from that turmoil, the Fed is expected to propose rules addressing practices like prepayment penalties and evaluating a borrower's ability to repay a loan. Individuals and groups have urged the Fed to ban or limit so-called "no-doc" loans and prepayment penalties, which are the fees charged when a borrower pays off a mortgage early.

Saturday, August 18, 2007

Ever Heard of the Minsky Moment – You May Want to Read About It

The following from the WSJ is an article about Hyman Minsky and his thoughts on the business cycle, speculation, and crisis in the financial markets. Although never popular amongst academics of his time, he is popular with some investors. (Which one is a mark of success?)

The recent market turmoil is rocking investors around the globe. But it is raising the stock of one person: a little-known economist whose views have suddenly become very popular.

Hyman Minsky, who died more than a decade ago, spent much of his career advancing the idea that financial systems are inherently susceptible to bouts of speculation that, if they last long enough, end in crises. At a time when many economists were coming to believe in the efficiency of markets, Mr. Minsky was considered somewhat of a radical for his stress on their tendency toward excess and upheaval.

Today, his views are reverberating from New York to Hong Kong as economists and traders try to understand what's happening in the markets. The Levy Economics Institute of Bard College, where Mr. Minsky worked for the last six years of his life, is planning to reprint two books by the economist -- one on John Maynard Keynes, the other on unstable economies. The latter book was being offered on the Internet for thousands of dollars.

Christopher Wood, a widely read Hong Kong-based analyst for CLSA Group, told his clients that recent cash injections by central banks designed "to prevent, or at least delay, a 'Minsky moment,' is evidence of market failure."

Indeed, the Minsky moment has become a fashionable catch phrase on Wall Street. It refers to the time when over-indebted investors are forced to sell even their solid investments to make good on their loans, sparking sharp declines in financial markets and demand for cash that can force central bankers to lend a hand.

Mr. Minsky, who died in 1996 at the age of 77, was a tall man with unruly hair who wore unpressed suits. He approached the world as "one big research tank," says Diana Minsky, his daughter, an art history professor at Bard. "Economics was an integrated part of his life. It wasn't isolated. There wasn't a sense that work was something he did at the office."

She recalls how, on a trip to a village in Italy to meet friends, Mr. Minsky ended up interviewing workers at a glove maker to understand how small-scale capitalism worked in the local economy.
Although he was born in Chicago, Mr. Minsky didn't have many fans in the "Chicago School" of economists, who believed that markets were efficient. A follower of the economist John Maynard Keynes, he died just before a decade of financial crises in Asia, Russia, tech stocks, corporate credit and now mortgage debt, began to lend credence to his ideas.


Following those periods of tumult, more investors turned to the investment classic "Manias, Panics, and Crashes: A History of Financial Crises," by Charles Kindleberger, a professor at the Massachusetts Institute of Technology who leaned heavily on Mr. Minsky's work.

Mr. Kindleberger showed that financial crises unfolded the way that Mr. Minsky said they would. Though a loyal follower, Mr. Kindleberger described Mr. Minsky as "a man with a reputation among monetary theorists for being particularly pessimistic, even lugubrious, in his emphasis on the fragility of the monetary system and its propensity to disaster."

At its core, the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they've taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. "This is likely to lead to a collapse of asset values," Mr. Minsky wrote.
When investors are forced to sell even their less-speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash. At that point, the Minsky moment has arrived.


"We are in the midst of a Minsky moment, bordering on a Minsky meltdown," says Paul McCulley, an economist and fund manager at Pacific Investment Management Co., the world's largest bond-fund manager, in an email exchange.

The housing market is a case in point, says Investment Technology Group Inc. economist Robert Barbera, who first met Mr. Minsky in the late 1980s. When home buyers were expected to have a down payment of 10% or 20% to qualify for a mortgage, and to provide income documentation that showed they'd be able to make payments, there was minimal risk. But as home prices rose, and speculators entered the market, lenders relaxed their guard and began offering loans with no money down and little or no documentation.

Once home prices stalled and, in many of the more-speculative markets, fell, there was a big problem.

"If you're lending to home buyers with 20% down and house prices fall by 2%, so what?" Mr. Barbera says. If most of a lender's portfolio is tied up in loans to buyers who "don't put anything down and house prices fall by 2%, you're bankrupt," he says.

Several money managers are laying claim to spotting the Minsky moment first. "I featured him about 18 months ago," says Jeremy Grantham, chairman of GMO LLC, which manages $150 billion in assets. He pointed to a note in early 2006 when he wrote that investors had become too comfortable that financial markets were safe, and consequently were taking on too much risk, just as Mr. Minsky predicted. "Guinea pigs of the world unite. We have nothing to lose but our shirts," he concluded.

It was Mr. McCulley at Pacific Investment, though, who coined the phrase "Minsky moment" during the Russian debt crisis in 1998.

Laurence Meyer, who served on the faculty with Mr. Minsky at Washington University in St. Louis, was a Federal Reserve Governor during those turbulent times. Mr. Meyer says that when he was an academic, Mr. Minsky's work didn't interest him very much, but that changed when he went into the real world. He says he grew to appreciate it even more when he was at the Fed watching financial crises unfold.

"Had Minsky been there, he probably would have been calling me and alerting me along the ride. And that would have been a good thing," Mr. Meyer says. "Every year that goes by, I appreciate him more. I hear myself sometimes and I think, oh my gosh, I sound like Hy Minsky."

Steven Fazzari, an economics professor at Washington University, says that Mr. Minsky would have supported the Federal Reserve's recent move to provide cash and cut the rate it charges banks on loans from its discount window to try to avert a financial crisis that could spill over to the economy. But he would probably be worried, too, that the moves might be bailing out investors who would all too soon be speculating again.

Having seen recent events unfold in the way his friend and former colleague predicted, Mr. Fazzari says, "I hope he's someplace saying, 'Aha, I told you so!'"