UBS – It Is Halloween and It Is Time For A Scary Story

I am not picking on UBS, but at least they are forth right in their comments of the bank and the credit markets going forward. The point is that there are still losses in future quarters that will have to be taken. Text in bold is my emphasis. The first portion of the post is from a WSJ article:

UBS AG's fourth-quarter warning stoked increasing anxiety that the pain from the credit-market turmoil that started this summer might last longer than investors had hoped.

But Switzerland's UBS warned yesterday of more potential losses ahead on U.S. mortgage-backed securities. The bank reaffirmed an estimate of a pretax third-quarter loss in the range of 600 million to 800 million Swiss francs ($515 million to $687 million). The bank, which has already announced a write-down of four billion Swiss francs in the third quarter, said the fourth quarter started well, but it may see further write-downs amid a new wave of downgrades on mortgage securities.

"UBS is not assuming that the quarter will continue as positively as it has begun, or that the current difficulties will be resolved in the short term," the bank said.

"There had been a feeling...that we'd seen the worst, and that the third quarter was going to be an opportunity for banks to basically clean out their balance sheets," said Simon Adamson, an analyst at credit-research firm CreditSights in London. But in the past week or two, there has been "a resurgence" of "nervousness and volatility, and concerns have resurfaced about the subprime market," Mr. Adamson says.

Much of the optimism was driven by hopes that credit markets would rebound once investors managed to separate good securities from bad. Instead, mounting losses on subprime loans and persistent waves of downgrades have begun to affect even the most highly rated securities, many of which are sitting on banks' books. A section of the ABX index that tracks the value of Aa-rated bonds backed by subprime mortgages was trading at only 50 cents on the dollar yesterday, down from roughly 65 cents on the dollar Oct. 19.

The second art is also from the WSJ and are comments made about the credit markets for mortgage backed securities:

As defaults and downgrades on mortgage-backed securities mount, banks, insurers and specialized funds around the globe are facing a problem: Some $60 billion in what were supposed to be perfectly safe investments are precipitating a new round of losses.

At issue are the so-called super-senior portions (or tranches) of collateralized debt obligations, investments that divide pools of securities into slices with different levels of risk and return. The tranches reaped the highest possible credit ratings because they were designed to be the last to suffer any losses.

But as the outlook for the U.S. housing market has deteriorated and defaults on mortgage loans have kept rising, chances have risen that losses on many CDOs -- those containing pools of lower-rated mortgage-backed bonds -- could reach all the way up to the super-senior tranches. As a result, billions of dollars in investments could be rendered worthless.

UBS AG Chief Executive Marcel Rohner shed light yesterday on the scale of the problem, calling a recent wave of ratings downgrades on mortgage-backed CDOs a "very serious second dislocation" that could prove painful for banks.

In October alone, ratings firms Moody's, Fitch Ratings and Standard & Poor's have downgraded or put on watch for downgrade more than $100 billion in CDOs and the mortgage securities they contain. Among the hardest hit have been so-called mezzanine CDOs, which consist entirely of lower-rated bonds backed by subprime-mortgage loans.

In a glimpse of how much banks have at stake, Mr. Rohner said UBS holds more than $20 billion of super-senior tranches, some two-thirds of which are part of mezzanine CDOs. They're among the reasons UBS, which yesterday reported a third-quarter loss of 830 million Swiss francs ($712.8 million), has warned that its investment bank is likely to face further losses in the current quarter. Nonetheless, UBS said the bank, boosted by its wealth-management business, should be profitable in the fourth quarter.

The potential for losses, analysts say, goes beyond the Zurich-based bank. Michael Hampden-Turner, a credit strategist at Citigroup Inc. in London, estimates that a total of some $60 billion in super-senior tranches of mezzanine CDOs are outstanding, mainly on the books of banks and specialized funds known as structured investment vehicles, or SIVs. Merrill Lynch & Co., for example, said losses on super-senior tranches accounted for most of the $8.4 billion third-quarter write-down involving CDOs and mortgage securities that it announced last week.

CDOs that own lower-rated mortgage-backed bonds are "one area that the market is particularly concerned about," said Mr. Hampden-Turner. Some ratings firms and analysts, he said, are forecasting scenarios in which the super-senior tranches would be rendered worthless.

Super-senior tranches were the biggest part of most mortgage CDOs that were underwritten by Wall Street in recent years. In many cases, they comprised 60% to 80% of the dollar value of each CDO, according to analysts.

Home Prices Continue to Slide

The following from the WSJ discusses the continuing slide in the price of homes. Text in bold is my emphasis.

Home prices continue to fall in most major U.S. metropolitan areas, according to the latest update of the S&P/Case-Shiller home price indexes.

Prices of single-family homes in 20 major U.S. metro areas in August were down an average of 4.4% from a year earlier, Standard & Poor's, reported yesterday. Prices in those metro areas fell an average of 0.8% from July to August, the fastest monthly decline in the seven-year history of the 20-city index.

Prices as measured by this index have been down from a year earlier for eight straight months. "The fall in home prices is showing no real signs of a slowdown or turnaround," said Robert J. Shiller, co-creator of the index and chief economist for MacroMarkets LLC.

The Case-Shiller indexes track multiple sales of the same homes in an attempt to screen out price differences caused by shifts in the size and type of houses being sold. Some housing economists consider these indexes the best gauge of national and metro real-estate values.

The biggest declines are in the Rust Belt and in the former boom towns near the coasts. In the Tampa, Fla., area, prices were down about 10% from a year earlier. Prices continued to rise, though at a more modest rate, in parts of the Pacific Northwest and the South.

Eight of the 20 metro areas recorded their largest-ever year-over-year declines in August. Prices were up in five metro areas, led by Seattle with a 5.7% increase and Charlotte, N.C., with 5.6%.

What Is Wrong With This Picture?

The Fed cut the Fed Funds rate by 25 bps (basis points) to 4.5% this afternoon as expected. It also cut the discount rate by 25 bps to 5%. See the following from CNN.Money:

The Federal Reserve lowered the target for a critical short-term interest rate by a quarter of a point Wednesday, citing continued concerns about weakness in the housing market.

But the Fed indicated that it is also worried about inflation, a sign that the central bank may be reluctant to cut rates again at its next meeting in December. . . . .

. . . . "Housing will continue to be a drag," said Thomas di Galoma, head of U.S. Treasury trading with Jefferies & Co.

"If the Fed sees weaker housing data, they probably will drop rates another quarter point later this year. In the back of everyone's mind, people are wondering how will banks and brokers come out of this. Those fears are not going away overnight," di Galoma added.

So far so good. Right?

As you might expect oil is up to an all time high of $96/barrel, gold is up to $796/oz., and the dollar hits an all time low against the euro of $1.45/euro. All this basically says the dollar is becoming worth less as time goes on.

So why is the stock market up?

By the end of the day the DJIA is up 137 points (+1.00%), the S&P 500 is up 18.36 points (+1.20%) and NASDAQ is up 42.41 points (+1.51%).

$100/barrel For Oil Is Not a Stopping Point

The excerpts below from an article in the WSJ summarizes the supply issues for crude oil. Assuming no severe economic downturn that would reduce the demand for oil, supply will continue to be the primary constraint in the market. This coupled with a falling dollar basically means that prices in excess of $100/barrel will be in the norm in the near future. People have done all sorts of predictions about what "Peak Oil" looks like, well this is what if looks like. Text in bold is my emphasis.

Several leading oil experts, gathered here yesterday for an annual energy conference, sketched a near-term future in which mounting global demand and shrinking supplies push oil prices well past the $100-a-barrel mark.

Consuming countries, they argued, will simply have to deal with the fact that new pockets of oil are getting far harder and more expensive to tap. That, combined with years of underinvestment by the industry, has led to a tapering off of new oil supplies that will continue for years, despite rising energy demand in Asia, the Middle East and some industrialized countries.

Prices have jumped nearly 40% since early summer, the oil ministers of Qatar and the United Arab Emirates said, because of the slumping dollar, widespread Wall Street speculation and bottlenecks in the refining process.

The debate over what is driving the surge in oil prices is sure to get more spirited if prices continue to soar and oil executives, consumers and politicians seek to assign blame. But the feuding theories at this year's Oil & Money conference also show how hard it is to pinpoint a cause.

Sadad I. Al-Husseini, an oil consultant and former executive at Aramco, Saudi Arabia's national oil company, gave a particularly chilling assessment of the world's oil outlook. The major oil-producing nations, he said, are inflating their oil reserves by as much as 300 billion barrels. These amount to hypothetical reserves that are "not delineated, not accessible and not available for production."

A lot of production in the Middle East is from mature reservoirs, and the giant fields of the Persian Gulf region, he said, are 41% depleted.

Global oil and gas capacity is constrained by mature reservoirs and is facing a "15-year production plateau," Mr. Husseini said. He predicted that supply shortages will continue to add $12 to the price of oil for every million barrels a day in additional demand. Global demand, now at some 85 million barrels a day, was on average 10 million barrels a day lower in 1999.

Nobuo Tanaka, the new executive director of the Paris-based International Energy Agency, which is funded by the world's leading industrialized consumer nations, said he sees little likelihood the world's spare capacity for oil production will increase notably in the near future, partly because so many oil-rich countries continue to shun outside investors.

"The IEA says that despite the high oil price, market tightness will increase from 2009, because new capacity additions won't keep up with reduced capacity from existing fields," he said.

IEA analysts insist that a sufficient resource base exists to supply demand through 2030, but Mr. Tanaka said he isn't confident there will be enough investment, skilled workers and technology to actually get to that oil "in a timely manner."

Andrew Gould, the chairman and chief executive of Schlumberger Ltd., an oil-services company, expressed similar concerns, noting that 70% of the oil fields that now quench world demand are more than 30 years old. The growth in global demand since 2003, he said, has been roughly the equivalent of the daily output from two of the world's larger suppliers: the North Sea and Mexico.

"Our industry simply cannot cope with these kinds of increases," Mr. Gould told the assembly. OPEC countries supply about 40% of world production. But that slice is expected to increase in coming years as output decreases in non-OPEC countries such as Mexico and Russia. Saudi Arabia, the world's largest single supplier, is looking to increase production substantially into the next decade.

But with oil prices now flirting with $100 a barrel, OPEC officials have been aggressive in batting aside talk that they are to blame. "The market is increasingly driven by forces beyond OPEC's control, by geopolitical events and the growing influence of financial investors," said Mohammed bin Dhaen al-Hamli, the United Arab Emirates' oil minister, who also serves as OPEC's president.

Mr. Hamli said prices still are "far below" the all-time inflation-adjusted high of $101 a barrel, set in the spring of 1980 after the 1979 Iranian revolution shocked oil markets.

Both ministers said the cartel won't formally consider whether to increase supplies to the world market during a heads-of-state meeting in Saudi Arabia next month. The group agreed last month to add about 500,000 barrels a day to world production, effective Nov. 1.

A top official at the Energy Department disputed OPEC's claim that supply isn't an immediate challenge. "We think the market still needs more barrels, as we look toward the next year or so," said Guy Caruso, an administrator at the department's Energy Information Administration. "The problem is we don't have cushions," in terms of spare production capacity and spare crude stocks, he said. "We have relatively low and declining inventories and a refining sector that's finding it hard to get the crude it needs."

Consumer Confidence Falls to Lowest Level in Two Years

The news does not seem to be getting better. From Market Watch:

Consumers are less upbeat about the U.S. job market, with an index tracking the level of their confidence sliding to its lowest level since October 2005, shortly after Hurricane Katrina hammered the Gulf Coast, economic data showed Tuesday.

The Conference Board's consumer confidence index fell to 95.6 in October from a revised 99.5 in September, the private research organization reported.

"This was the third straight hefty fall, and it seems to suggest that the relative strength of the stock market is no longer enough to offset the impact of the housing disaster," wrote Ian Shepherdson, chief U.S. economist with High Frequency Economics.

"Further weakening in business conditions has, yet again, tempered consumers' assessment of current-day conditions and may very well be a prelude to lackluster job growth in the months ahead," said Lynn Franco, economist for the Conference Board.

The percent of consumers with plans to buy a home within the next six months decreased from 3.0% in September to 2.7% in October -- the lowest rate since November 2004, according to the Conference Board. The percent with plans to buy a major appliance in coming months fell from 29.8% to 25.9% -- the lowest level since October 2005.

"This is really reflective of the downturn in housing," Franco said.

Cutbacks in major appliance purchases are "a sure sign of consumer strain and should be taken seriously," wrote Tony Crescenzi, chief bond market strategist for Miller Tabak & Co.

"This report is very negative in what is says about the U.S. economy," he wrote. "The figures are not recession-like," but they are indicative of a trend that could become difficult to arrest.

Also, consumers are growing more pessimistic about the short-term future and their "rather bleak outlook suggests a less-than-stellar" end of the year, Franco noted.

Will We Escape A Recession?

The excerpts below are from an article in Market Watch, that discusses why we may not escape a recession. A question that I have is: is there really a big difference between the economy growing at 1.5% or a -1.5%? I don't think so and we are probably headed for one of those places. Also as the economy slows many forecasters were predicting an economic slowdown in the Q3 - Q4 time frame. It appears that this may have to be rolled back 3 to 6 months. Text in bold is my emphasis.

. . . . many economists are skeptical. . . . . they are seriously concerned that the economy soon could slip into a recession. Economists are advising investors to ignore all festivities planned after the third-quarter gross domestic product report is released on Wednesday morning

It is the growth in the next two quarters where the rubber meets the road. Analysts expect growth in the fourth quarter to slow to around a 1.5% rate, less than half of the third quarter. They call the January-March quarter of 2008 "the dangerous quarter" for a sharp slowdown.

If these worries prove correct, any amount of further Federal Reserve rate cuts expected this week and over the next few months likely won't stop a sharp downturn, but would just soften the blow.

Federal Reserve vice-chairman Donald Kohn seemed to hint at the Fed's powerlessness when he said in a recent speech that the Fed's half-point rate cut in September "will not be able to avert all of the weakness in the economy that may be in train for the next several months."

In addition, the most recent Fed Beige Book report, which is a collection of anecdotal report of the central bank's business contacts, gave off a gloomy glow. And the minutes of the Fed's Sept, 18 meeting reported the Fed staff had trimmed its forecast for growth in the fourth quarter and 2008.

Douglas Holtz-Eakin, former chief of the Congressional Budget Office and now an expert on the U.S. economy at the Peterson Institute for International Economics, said his gut tells him the economy might be weaker at the moment than the economic indicators show.

The key factor, he said, is that business confidence appears to be weakening sharply. The current economic situation reminds him of the slow recovery in 2002. As the economy exited a recession then, the fundamentals improved but job growth remained weak. It turned out the hidden factor was that businesses stayed in a sour mood even though the recession was over.

The fact that business confidence is now at the same low level as 2002 "gives me reason to be more nervous than I otherwise would be," Holtz-Eakin said.

Robert Brusca, chief economist at Fact and Opinion Economics, said he also sensed "there is something going on out there that isn't good...I am concerned about the economy. It is looking pretty weak to me."

One reason the recession fears haven't gained more prominence is that economists are generally loathe to forecast serious downturns.

Carl Tannenbaum, chief economist at La Salle Bank in Chicago, who used to compile economists' surveys from the National Association of Business Economics, said he doesn't recall ever seeing a formal forecast of a recession.

What generally happens in a recession is that the economy starts to slow down, and then growth just falls sharply. None of the complex econometric models in use can forecast this break.

"Most of the models are continuous, where the economy strengthens a bit or softens a bit. It is quite difficult to deal with what could be a step-change, where you get some tipping point where everyone decides it is time to cut back on hiring and capital spending. When that happens, pretty soon everything snowballs into a major slowdown," said Nigel Gault, economist at Global Insight.

In recent months, consumer confidence has dropped, job growth is weak, and the unemployment rate has started to rise.

But, at the moment, economists will go no further than saying the odds of a recession are one-in-three.

But the housing sector, credit crunch and the price of oil price above $90 has economists watching closely.

"There is a feeling out there that there is more bad news to come," said Gault.

Tannenbaum of La Salle Bank said he is beginning to pick up signs that commercial real estate is leveling off. He said this is a good coincident indicator of job growth as new workers need space.

At the same time, almost everyone agrees the housing market will continue to weaken, and home prices may fall sharply.

Tannenbaum says greater job growth is needed to keep out of danger: "If we continue to create 100,000 jobs a month, I think we can work our way through it. But if we get a negative payroll report that is a true negative, that is the kind of chain reaction that could end the expansion," he said.

One factor arguing strongly against a recession is the stock market, which seems optimistic about the longer-term outlook, even as the bond market is priced for bad news.

Another wild-card is the Christmas shopping season, which could always turn out to be better than the current gloomy forecasts.

So the key is whether the economy gets through the October -March period unscathed.

Before You Jump, Understand The Real Cost of the Losses at Merrill Lynch

In reading the comments on this blog and others many are very adamant that companies like Merrill Lynch or Citigroup (or whatever) should pay totally for the mistakes they made in the credit markets. So if they fail “so be it”. Just realize that these are very large firms that employ a lot of people. Forget the few executives that made a series of profit driven decisions without properly weighing the risk. There are a lot of people that get up every day, go to work, do a good job, support a family, etc. What do you do with those people? It is easy to make quick judgments, but in many cases the human cost of the decisions come at a very high price. Don't get me wrong, I am not condoning what many of these firms did, but one needs to look at the total cost of their failure. Besides where were the regulators, the board of directors, the risk department, auditors, and shareholders when all this was occurring? No group in their right mind pushes for big profits today when they realize that they could lose it all six months from now. How come no one is talking about these people?

Text in bold is my emphasis. From Bloomberg:

The real damage to shareholders came with Merrill's $8.4 billion writedown. It is the biggest in the history of Wall Street and wiped out four quarters of growth in shareholders' equity, according to Merrill's published figures. The charge, mostly for collateralized debt obligations and subprime mortgages, left the New York-based company with $38.8 billion of assets minus liabilities.

Losing ``20 percent of shareholders' equity in one fell swoop is a serious blow,'' said Robert Willens, the accounting analyst at Lehman Brothers Holdings Inc. in New York. ``It might take them two to three years to earn that capital back.''

``What they lost is likely to be more than they made in the last two years in CDOs,'' Hintz said. ``You can't put it all down to CDOs, but it's not a bad estimate.''

Merrill estimates it had $38.8 billion of shareholders' equity at the end of September, down from $42.2 billion in June.

The firm still has $15.2 billion of CDOs, less than half the amount it held at the end of June. Merrill may have to write down another $4 billion in the fourth quarter, said Meredith Whitney, a New York-based analyst at CIBC World Markets, in a note to clients last week.

The Purpose of the VULTURE in the Housing Market

This is a great article from CNN.Money about the vulture in the mortgage securities market. Please realize that the same thing is happening in the housing market. If one is interested in buying a house today the bidding should start at 50 cents on the dollar and if the seller is not willing to at least counter, then the buyer should move on to the next house. It is a "New Market", the old rules do not apply. Text in bold is my emphasis.

Since the subprime crisis erupted earlier this year, vulture investors looking for bargains have been circling battered securities backed by mortgages.

While opportunistic investors may be reviled by some, their presence is often an indication that a beaten down market has reached a bottom. The longer they stay away, the more likely it is that turmoil will roil the market.

"[Distressed debt investors] are a good thing for the market - they're a new force for providing liquidity," said Mark Adelson, an independent mortgage securities analyst.

For sure, vulture investors are getting ready to strike. Fundraising in the first nine months of the year hit a record $6.6 billion, according to London-based Private Equity Intelligence.

The research firm doesn't break down how much of that total is directed at risky mortgage-related debt, but several high-profile investors are eyeing the sector. The market chattered last month about a new $2 billion fund by Pacific Investment Management Co. Distressed debt investor TCW Group and hedge-fund firm Marathon Asset Management also have been said to be making moves in the sector.

The mortgage meltdown has sent many investors fleeing from risky mortgage bets like subprime-backed securities and collateralized debt obligations, which are pools of bonds sold off in slices of varying credit risk. It has also brought out vulture investors who, as their name suggests, smell an opportunity.

These investors face the difficult task of determining when prices for the distressed securities have hit a bottom. Until they're sure they're getting a bargain, they're likely to hold back on investing their money.

"It's not that no one's going to want to touch [subprime securities]. The question is at what price," said Adelson, who used to head structured finance research at Nomura Securities.

But the securities are hard to value, and no one knows if things are going to get worse. Merrill Lynch said last week that it took a $7.9 billion loss on mortgage-related assets in the third quarter. That was about $3.4 billion higher than the writedown the bank had projected a little more than two weeks earlier.

Furthermore, a recently created "superfund" designed to buy bonds and other debt backed by home loans could deter distressed investors from entering the market.

Some critics, including former Federal Reserve chairman Alan Greenspan, have warned that the fund could do more harm than good by propping up prices.

"If you intervene in the system, the vultures stay away," Greenspan said in a recent interview with Emerging Markets Magazine. "The vultures sometimes are very useful."

That some players are starting to sniff around the mortgage sector is a good sign that the market may be starting to stabilize.

Still, the murky economic outlook has left some experts anticipating a further drop off in prices of mortgage-backed securities. And there are signs the housing woes could get worse. For example, analysts are bracing for a massive wave of mortgages to reset to higher interest rates and trigger another wave of delinquencies.

The uncertainty leaves distressed debt investors with the tricky task of "catching a falling knife," said Daniel Alpert, a partner at New York-based boutique investment bank Westwood Capital, which specializes in mortgage and related securities.

"You could argue this is a good time to go in," Alpert said. "But my view is that a good portion of the market thinks the knife hasn't even started to plummet yet."

This last comment are my sentiments about the market. If you have money now is a good time to stand around on the sidelines with your hands in your pockets

Comments

In case you did not notice everyone is now able to comment, a google password is no longer required. So please feel free to comment as often as you like. I am trying to encourage commenting because I don't know everything; other people have very good points of view and I like to hear them; and I enjoy a good, well-reasoned discussion.

3 basic rules for commenting:

1. No swearing.

2. No calling other commenters names.

3. No advertising or promoting products, services, stocks, etc.

I do have editorial control of the comment page and I do delete comments. So far, it has always been someone trying to sell something.

SIVs 101

I posted this over the weekend and it did not get many hits (people have other things to do on weekends besides reading various business/economics/finance blogs - how about that). This is a very nice and quick intro to SIVs in slide format.

http://money.cnn.com/galleries/2007/news/0710/gallery.superfund/index.html

Some Opinions About SIVs or Should I Say SIVilis?

No, I did not originate the word SIVilis, but it is kind of funny. The article below from CNN.Money gives another point of view about the big bank bail-out fund (MLEC). Did you notice that as time passes we get closer to the truth about what is actually happening. This is playing out just right, it is about time people see what “high finance” is really like. After a while it actually makes sense. The cost of a large bank failing is so costly and so destructive, that it make sense to bail them out, although morally it grates on everyone’s nerves. Welcome to the world of 10,000 shades of gray. Text in bold is my emphasis.

This may sound silly, but let me ask you a question. Let's say that I maxed out my credit at Citigroup to speculate on a house whose market price is now less than what I paid. Citi wants its money, but instead I say, "Sorry, the house is selling for less than its true value. As soon as it sells for what it should, I'll send you a check." What do you think Citi's reaction would be? How about "Sir, where should I send the repo man?"

Well, folks, Citigroup seems to have put itself in just such a fix by borrowing lots of money to buy assets that have dropped in market value. But instead of summoning the repo (as in repossession) man, some of the world's biggest hitters are trying to set up a huge fund to buy time for Citi and some other institutions with similar problems.

The idea is to set up a $100 billion "master liquidity enhancement conduit" (MLEC) to take some of the $80 billion of suspect securities off Citi's hands so that it doesn't have to sell them in the current market. Other institutions have about $300 billion worth. (This conduit is being called a superfund, to the delight of those of us who live in New Jersey, for whom the term evokes images of toxic industrial waste. But I digress.)

The problem here, as you probably know, involves seven of Citi's "structured investment vehicles," known as SIVs. They borrowed short-term money to buy long-term assets, such as mortgage-backed securities, that have fallen in market value.

Regulators and various big institutions are trying to stabilize things to avoid what we can call SIVilis. That's a financially transmitted disease that could infect the world's financial markets, leading to cascading failures and other consequences too dire to even think about. In my mind the regulators should have been pushing safe sex so Citi does not get SIVilis.

Citi won't talk to us about SIVs. The only player who would go on the record is Treasury Secretary Hank Paulson, whose department is in charge of maintaining orderly financial markets.

The problem, Paulson told FORTUNE, is not merely "the repricing of risk" but also analyzing the immensely complicated securities the SIVs own. "What you're dealing with here is complexity," he told us, and the proposed master conduit would pool not only money but analytical information as well. An interesting concept.

Paulson wouldn't discuss Citigroup or provide details about how bad SIVilis is. But he gets points for coming out and talking.

Citi clearly screwed up with its SIVs. When a financial institution borrows short term to buy long-term assets, it's supposed to have a plan for when its bet goes bad - rather than just whining about "disorderly markets."

Citi now says it has put together enough borrowings to carry its SIVs through year-end, which may be why Paulson told us the problem "isn't urgent."

If Citi's only problem is that it can't liquidate its SIVs without a profit hit, too bad. If Citi's very existence is at risk, I don't think we dare let it fail, because that would drag down institutions throughout the world. But if the bank needs help, its shareholders should have to pay. Bigtime.

Step one would be to eliminate its common stock dividend, currently more than $10 billion a year. Step two would be to force Citi to raise the capital it needs by selling new stock at a price well below its recent $42 a share. That would force holders to either ante up or have their Citi stake diluted. That just might inflict enough pain on shareholders that someone other than underlings would pay for Citi's SIV sloppiness.

In any event, if we believe in markets, Citi should have to take its chances. We small fry take chances when we borrow, and we pay the price if we're wrong. Big fish should have to do the same.

Joint Economic Committee (of Congress) Discusses the Sub-Prime Problems

Below is the Executive Summary for the Joint Economic Committee (JEC) report on the subprime crisis. This reports is 32 pages long with lots of graphs, charts, tables, and maps. This report does not pull any punches, although the report admits that it uses a mid-level forecast for housing deterioration and if the forecast is too optimistic then the situation will be worse. A must read.

As the losses caused by the subprime lending crisis continue to work their way through the financial markets, there is a growing awareness among policymakers and financial market regulators that we need to prevent the continuing foreclosure wave from affecting the broader economy. A significant increase in lax (and often predatory) subprime lending during a period of rapid housing price appreciation put risky adjustable rate mortgages in the hands of vulnerable borrowers who are now facing substantial payment shocks and risk foreclosure when their loans reset this year and next.

Part I of this report shows that unless action is taken, subprime foreclosure rates are likely to increase as housing prices flatten or decline, and the effects of the subprime crisis are likely to extend beyond the housing market to the broader economy. The decline in housing wealth will negatively affect consumer spending, and the forced sale of large numbers of homes is likely to negatively impact the prices of other homes.

Part II of this report shows that, unless action is taken, the number and cost of subprime foreclosures will rise significantly. For the entire 2007 through 2009 period, if housing prices continue to decline, we estimate that subprime foreclosures alone will total approximately 2 million.

Part II also includes forward looking, state-level estimates of subprime foreclosures and associated property losses and property tax losses, covering the second half of 2007 through 2009. For that shorter period, and assuming only moderate housing price declines, we estimate that:

• Approximately $71 billion in housing wealth will be directly destroyed through the
process of foreclosures.
• More than $32 billion in housing wealth will be indirectly destroyed by the spillover effect of foreclosures, which reduce the value of neighboring properties.
• States and local governments will lose more than $917 million in property tax revenue as a result of the destruction of housing wealth caused by subprime foreclosures.

Part III of the report highlights the underlying causes of the subprime crisis and explains how incentive structures in the subprime market work against the interests of borrowers and have had much to do with the dimensions of this crisis.

Finally, in Part IV, policy options aimed at reducing foreclosures and preventing the crisis from reoccurring in the future are offered.

Head of Merrill Lynch Resigns

The excerpts below from a fairly long article in the WSJ, speaks for itself. However, I am very curious as to what we are not seeing. Text in bold is my emphasis.

Chief Executive Stan O'Neal has decided to leave the firm, according to a person familiar with the matter. . . . .

. . . . Directors have grown increasingly frustrated since Merrill announced $5 billion in write-downs three weeks ago. In the past week, the size of the hit grew by more than $3 billion, and Merrill reported a $2.24 billion net loss for the third quarter. Analysts say several billion dollars in additional write-downs may be in store. . . . .

. . . . The latest board meeting came after news that Mr. O'Neal had approached Wachovia Chief Executive G. Kennedy Thompson in the past week about whether the Charlotte, N.C., bank would be interested in a combination with Merrill. Mr. O'Neal didn't consult with the board before making the phone call. Mr. Thompson, who has said he is focused on integrating two recent acquisitions, said the timing wasn't right for a deal, people familiar with the matter said.

What Does It Feel Like When You Are At The Top Of Niagara Falls and You Look Down?

I have been in banking (or near) banking for almost three decades and I just don’t see any of this ending well. Text in bold is my emphasis. From the NY Times:

THE props holding up the values of risky mortgage securities finally started to give way last week. And that means the $30 billion in losses and write-downs taken by big brokerage firms in the third quarter are not likely to be the last.

Even as developments in the credit markets went from bad to worse this year, investors for the most part have remained upbeat about the values of the mortgage securities they held. One reason that they could keep their heads in the sand was that these complex securities are hard to value in good times, impossible during periods of stress.

Executives of companies with big stakes in mortgages also accentuated the power of positive investor thinking. Emerging periodically from their corner offices, these executives opined that in spite of rocketing delinquencies, most loans continued to perform well. Rating agencies, fending off complaints that they had been slow to downgrade, maintained that they would adjust their ratings only after they saw actual loan failures. Government officials trotted out regularly to contend that upheaval in the mortgage market was a minor scrape.

After last week, however, it was no longer plausible to deny that mortgage loans, and the complex securities derived from them, had crashed — and caused a lot of damage in the process.

First to face the music was Merrill Lynch, which stunned investors Wednesday with an $8.4 billion write-down, $7.9 billion of which was for mortgage-related assets. The write-down was $3.4 billion more than it had warned investors about just three weeks before.

Until that moment, investors had been willing to trust companies claiming to have limited exposure to the credit mess. But Merrill’s third-quarter results made clear that such confidence must now be earned, not presumed.

In a pained, hour-long conference call, Merrill’s top executives said that almost $8 billion of the firm’s capital had been vaporized in the third quarter because it had underestimated the degree to which its holdings of collateralized debt obligations, or C.D.O.’s, had tanked. C.D.O.’s are pools made up, for the most part, of mortgage securities divvied up into tranches of differing risk levels.

The executives on Merrill’s dismal conference call conceded that even after they decided to value their C.D.O. holdings more conservatively — resulting in losses — much of their methodology was based on “quantitative evaluation.” (For the rest of us, that means that Merrill was in the unfortunate position of still having to guesstimate its exposure to losses.)

ANALYSTS quickly responded by forecasting an additional $4 billion in write-downs on Merrill’s portfolio. Marking positions to model — a favorite reality dodge on Wall Street — just doesn’t cut it anymore.

To be sure, Merrill was especially overexposed in C.D.O.’s, choosing as it did to go into the business relatively late but in a very big, very voracious way. Other banks and brokerage firms are not likely to have as much junk on their books.

Nevertheless, Merrill’s decision to write down its holdings as it did gives a clear signal to other banks and brokerage firms that valuing similar assets at lofty levels is no longer acceptable or credible.

Then, on Friday, Moody’s Investors Service began downgrading C.D.O.’s. Despite the subprime turmoil, some of these securities had continued to carry high ratings — until Friday. Moody's cut or placed on review for possible downgrade securities from dozens of C.D.O.’s, some rated as high as AAA. The C.D.O.’s that may be subject to a downgrade hold subprime mortgage loans worth $33 billion, and there are probably more to come.

Moody’s move was not a surprise. It warned several weeks ago that C.D.O.’s were finally coming under its microscope. But Moody’s downgrade is notable because many investors holding C.D.O.’s — like insurance companies — have to sell them when their ratings fall significantly.
With the C.D.O. market stopped dead in its tracks, it is not clear who will be willing to buy and at what price. But it’s a good bet that these forced sales aren’t going to add buoyancy to the market. A better bet may be to expect Wall Street to recognize further losses.

“We’ll definitely see a lot more write-downs,” said Josh Rosner, an expert on asset-backed securities at Graham-Fisher, an independent research firm in New York. “I think that the exposures that we are seeing and the announcement out of Merrill are the leading edge, not the end.”

ONE reason that Mr. Rosner expects more losses from banks and brokerage firms relates to the calendar. So far, the write-downs that banks and brokerage firms have taken have come during periods when managements were preparing their financial statements but hadn’t submitted them to outside auditors for a more thorough vetting.

Intense auditor scrutiny comes once a year, and that is the period we are in now — fiscal years at many big brokerage firms, Morgan Stanley, Leham Brothers and Bear Stearns, for example, end in November.

“When it comes time for the auditors to attest, they are going to be very conservative,” Mr. Rosner said. That means write-downs will have to reflect the reality in the market, not some rosy scenario.

Way back in 2003, Warren Buffet defined derivatives — like those exploding on a balance sheet near you — as financial weapons of mass destruction.

“The derivatives genie is now well out of the bottle,” he wrote, “and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear.”

Last week, Merrill Lynch shareholders got a taste of that toxicity. Others will soon have their turn.

A Review of the Banking Industry – Is a Credit Crunch On The Way?

The excerpts below from an article at MSN.Money gives a very good summary of the current state of the banking industry and why a credit crunch may be on its way. Text in bold is my emphasis.

The horrors let loose among mortgage borrowers and lenders by falling housing prices have begun to sink their fangs into the market for auto loans and credit cards, too. We're inching dangerously close to the point where consumers run for the hills -- taking their wallets and prospects for economic growth in the United States with them.

The damage came from two directions: mortgage delinquencies and assets backed by mortgages. At Citigroup, for example, delinquencies soared in September. The percentage of first mortgages more than 90 days past due climbed that month to 2.09% from 1.29% a year earlier, and second-mortgage delinquency rates doubled from earlier in 2007. And losses from Citigroup's investments backed by mortgages climbed to $1.56 billion for the quarter. That was well above the $1.3 billion loss the company had pre-announced just weeks earlier.

The damage was similar at other big banks:

Washington Mutual reported a net loss of $222 million from selling mortgage loans that it didn't want to hold in its own portfolio. That was a big switch from the $192 million gain on sale in the second quarter. Nonperforming mortgage assets increased to 1.65% at the end of the quarter, up from 1.29% at the end of the second quarter.

At Bank of America, the quarter saw a $527 million loss from structured debt products including mortgages and a doubling in nonperforming assets to $3.4 billion.

Wachovia reported a $587 million increase in non-performing residential real-estate loans and a $127 million increase in residential mortgage foreclosures.

At Wells Fargo, net credit losses rose to $892 million from $663 million in the third quarter of 2006.

Altogether, U.S. banks raised their reserves against loan losses by $6 billion in the third quarter from reserve levels at the end of the second quarter of 2007.

That's bad news for bank stocks, certainly. Every dollar that goes into reserves is a dollar less that can be lent out to make money. And the levels of reserves don't look likely to fall in the near future. Washington Mutual, for example, told Wall Street analysts that it expects that charge-offs in its mortgage portfolio will increase by 20% to 40% in the fourth quarter.

But the really scary news for the general economy is that the banks' problems aren't limited to mortgages and the housing market. They're starting to see rising delinquencies and charge-offs in their portfolios of auto loans and credit card debt.

Wells Fargo, for example, said that charge-offs on its credit card portfolio rose to $176 million from $161 million in the second quarter. At Washington Mutual, managed credit card delinquencies climbed to 5.73% of the bank's portfolio from 5.11% in the second quarter.

A "credit crunch" means that banks cut back on lending because of past losses. But now credit card companies are "crunching" customers -- raising fees, cutting limits and more -- and that could hurt spending, says MSN Money’s Jim Jubak.

But the most stunning news -- and the most troubling indicator that credit problems aren't limited to the mortgage market anymore -- came from the credit card companies. Because these lenders have neither direct nor indirect exposure to the mortgage market, the trends here are an indicator of what's happening with consumer credit outside mortgages. And the news in the third quarter wasn't good.

For example, American Express in its Oct. 22 third-quarter earnings report, put aside an additional $196 million in the third quarter, a 44% jump from the end of the second quarter, for loan losses in its credit card portfolio. The company's total provision for loan losses climbed 25% in the quarter to $982 million. Outstanding loans climbed 23% for the quarter, trailing both the percentage increases in credit card and total loan-loss provision.

At Capital One Financial, credit card charge-offs climbed to 4.13% and delinquencies to 4.46% in the third quarter. The company increased its loan-loss provision in its auto-loan business by 34% from the second quarter. Total loan-loss provision climbed 32% from the third quarter of 2006 and 28% from the second quarter of 2007.

There are other explanations for some of these numbers. Capital One Financial recently moved to add an indirect channel for making auto loans, which has led to a jump in delinquent loans. During its conference call, Capital One Financial called this move a mistake and announced that it was moving the auto-loan business back to a direct-lending model.

Rising industrywide delinquency and default rates are, to some degree, a return to normal after atypical lows following the rush to bankruptcy caused by a change in bankruptcy laws that took effect in October 2005, which cleared a lot of bad debt out of lenders' portfolios.

But taken together, with evidence of rising delinquency and default rates coming from so many different lenders operating so many different business models in so many different markets, the possibility that we're seeing the troubles that borrowers are facing with their mortgages spill over into problems with credit cards and auto loans is disquieting.

These problems could indeed slow the economy in 2008 more than investors now believe is likely.

The biggest danger, though, doesn't come from the consumers running behind on their credit cards and their auto loans. With delinquency rates still below 5% at a credit card company like Capital One, reduced spending by consumers with credit problems probably isn't enough to tank the economy.

It's the folks in good shape that the economy has got to watch out for. If consumers who are in good shape decide to cut back on spending in order to reduce their credit card balances, that would take a considerable amount of spending out of the economy. There is some evidence that this has started to happen. Repayment rates are running about 1 percentage point above their long-term average, according to Bankstocks.com. And credit card utilization rates -- the amount of available credit that consumers actually use -- are near 15-year lows.

The banks aren't helping the situation. Certainly, you understand why a bank that's been burned by higher-than-expected mortgage default rates would think first about cutting back on mortgage lending. It's too little, too late, but the impulse is almost irresistible. In the mortgage market, lenders have lowered the amount they'll let consumers borrow against their homes, done away with teaser rates and no-income-verification loans and raised the credit scores they require to approve a loan. The result is a credit crunch where people who want to borrow today can't -- even though they meet the lending standards in effect just yesterday -- because lenders have stopped lending.

Something similar may be brewing in the credit card market. Through the first six months of 2007, direct-mail offers to consumers with the best credit have dropped by 13%, according to Mintel International. (On the other hand, offers to consumers who are in danger of defaulting on their home loans have actually climbed by 41% in the same period.)

At the same time as they're sending out fewer card offers to the best prospects, banks have been increasing the rates they charge on cards:

Regular monthly interest rates are going up.
Penalty interest rates are going up -- to as much as 34% in some states -- for cardholders who make even one late payment.
More cards are adding a universal penalty clause where missing a payment on one card you hold can trigger a rate increase on all your other cards.
Late fees have zoomed and so have over-limit fees.
Grace periods that allow you to pay before interest charges kick in are getting shorter.
It's harder to get a credit card company to raise a credit limit on an existing card, and new card offers come with lower initial credit limits.

A "credit crunch" means that banks cut back on lending because of past losses. But now credit card companies are "crunching" customers -- raising fees, cutting limits and more -- and that could hurt spending, says MSN Money’s Jim Jubak.

Most of those changes, in my opinion, are simply attempts by banks and other credit card issuers to pull in more revenue from cardholders to offset the squeeze on their profits that results from putting more money into loan-loss reserves. They don't intend to create a credit crunch. But by lowering credit limits and by making it more expensive and more aggravating to use a credit card, the result is still the same. We're witnessing the very early stages of a classic credit crunch in the credit card market.

It's too early to tell if the crunch will get crunchy enough to take a percentage point or two out of the 1.9% growth rate projected for the U.S. economy in 2008. But in this part of the debt market -- as in so many others from mortgages to buyout loans -- the trend is clearly toward less available and more expensive credit. That's never a recipe for faster economic growth.

The Strategic Petroleum Reserve – A Review

Do you remember the Strategic Petroleum Reserve (SPR), that reserve of crude oil formed during the Carter administration? There is a lot of talk recently about the SPR, but ultimately it just isn’t that big. Text in bold is my emphasis. From the WSJ:

Lawmakers and oil analysts want to know why the Bush administration, at a time of sky-high oil prices, insists on pumping 50,000 barrels a day of some of the world's most desirable crude into salt caverns in Texas and Louisiana.

The question centers on the country's huge Strategic Petroleum Reserve, which now holds 694 million barrels, or enough to replace 69 days of U.S. crude imports. Critics of the Energy Department argue the administration could ease concerns over lofty prices simply by not pumping additional oil into the reserve and putting the extra barrels on the market instead.

Filling the reserve is the latest wrinkle in a larger debate over its role. Should the U.S. turn to the petroleum stash to calm oil markets, as governments often increase spending when the economy slows? Or should it be used only in times of true crisis, like another war in the Middle East or a massive hurricane like Katrina?

Energy Department officials say it makes sense to keep filling the reserve at the current rate. They say that Bush administration has no intention of changing course, whether to send signals to the market or otherwise.

Megan Barnett, an Energy Department spokeswoman, said the input is "a minute amount compared to over 20 million barrels per day consumed in the U.S. and over 80 million barrels consumed globally every day." The extra oil, she said, "helps to provide an added layer of protection to Americans in the case of a severe supply disruption."

Of particular interest is the growing premium buyers are now paying for low-sulfur crude, the mainstay of what the Energy Department is now pumping into the reserve from suppliers in the Gulf of Mexico. The reserve now contains 276 million barrels of sweet crude, with the rest being the less-desirable heavy, sour variety. "Sweet" crude yields more premium refined products like gasoline.

"Sweet crude is the Château Haut-Brion of oil," says Philip Verleger, an independent energy economist based in Colorado who is clamoring for the government to dip into the reserve.

Larry Goldstein, director of the Energy Policy Research Foundation in Washington, says the crimp in sweet-crude supplies "makes this an opportune time for the government to rethink its policy. This would be a tinkering with the market, not a tampering."

The government isn't paying cash for the oil. Instead, private producers supply the government with oil as part of a royalty-in-kind program to pay for the right to drill in U.S.-controlled offshore waters. About 1.5 million barrels a month of this royalty oil is now flowing into the reserve.

But skeptics argue it would be smarter for the Energy Department to sell the oil and buy up additional reserves when prices subside, as many expect they will next year. Senate Democrats, in their letter to Mr. Bodman, argue that Congress wants the department "to use a market-based approach to determining when to fill the SPR."

U.S. officials say they aren't continuing to fill the reserve with a particular contingency in mind. The U.S. decided to create a petroleum reserve system right after the 1973-74 Arab oil embargo, and began filling the first salt caverns in 1977. The Energy Department now describes the reserve as "a significant deterrent to oil import cutoffs and a key tool of foreign policy."

The reserve has been tapped in the past for emergencies. During the 1990-91 Gulf War, the government pulled 21 million barrels. President Bush opened the spigots in 2005, after Hurricane Katrina caused massive damage to oil facilities in the Gulf of Mexico in 2005, putting another 21 million barrels on the market. The reserve has also offered to swap or loan oil during limited supply disruptions.

But President Clinton in the late 1990s turned to the reserve to address less calamitous needs. Citgo Petroleum Corp., part of Petroleos de Venezuela, and the forerunner of ConocoPhillips together borrowed a million barrels from the reserve in June 2000 when an accident cut off supplies to two of their huge refineries in Louisiana. Twice that same year the administration tapped the reserve to offset surging heating-oil prices in the Northwest.

The Bush administration has been determined to boost the reserve, which stood at 544 million barrels in September 2001. The government expects to fill the reserve to its 723 million-barrel capacity by the end of next year.

At the same time, the Energy Department is moving ahead on plans to eventually expand the reserve to a billion barrels. President Bush in January called for an even greater expansion to 1.5 billion barrels, though it is unclear whether Congress would appropriate the massive sums needed to buy and store that much oil at current prices.

The Weekend’s Contemplation – Emerging Markets Can’t Pick Up the Slack

Over the last several months there have been a number of posts on whether or not the rest of the world would slide into a recession if the US slid into a recession. Some believe that if the US slides into a recession other economies will not because their economy is sufficiently strong to get along without us (the whole idea behind de-coupling). Others believe that the opposite, that economies outside the US, primarily emerging markets, lack the size to make up for the US. This article from Bloomberg supports the latter position. Text in bold is my emphasis.

China is among the world's fastest- growing economies. Shanghai and Shenzhen are home to its hottest stock market. Now many investors regard the evolving Asian behemoth as the antidote to a slowing U.S. economy, picking up the slack in global growth as the American consumer retreats.

They probably shouldn't. China's growth has been fueled by exports and investment, not consumers, whose share of the country's gross domestic product is declining. From almost 80 percent in the first half of the 1980s, Chinese household consumption fell to 46 percent of GDP by 2000 and shrank further to 36 percent in 2006.

``The average consumer in China isn't a credit-card-toting shopper roaming malls in search of fashionable jeans or a large- screen television,'' says Joseph Quinlan, New York-based chief market strategist at Bank of America Capital Management.

Instead, the Chinese are savers. The average household banks a quarter of its after-tax income. That's to compensate for reduced government outlays for health care, unemployment benefits and pensions; more costly housing; the loss of guaranteed lifetime employment; and rising school-related expenses in a country obsessed with education.

``While China's global presence in certain industries has grown in significance over the past decade, Chinese consumers are not ready to drive global demand,'' Quinlan says. ``The Chinese are in no position to fill a consumption vacuum left by the U.S.''

China is part, a big part, of a growing consensus that emerging-market countries, can not only break free of their traditional dependence on the American consumer but that their own expanding domestic demand can cushion the global impact of a slowing U.S. economy.

Proponents of this thesis that the meek shall inherit the Earth -- or, at the very least, help stabilize it -- include Goldman Sachs Group Inc., Merrill Lynch & Co. and Lehman Brothers Holdings Inc.

Strong growth in emerging markets ``could balance the drag effect from the world financial turmoil,'' Lehman told clients at the end of August. On Sept. 12, Goldman economists boldly proclaimed: ``Our view of global decoupling has become the consensus view.'' Emerging markets generally and the so-called BRICs -- Brazil, Russia, India and China -- specifically, are key to global decoupling, they said.

The four BRICs, which sport growth rates of 5.4 percent to 11.5 percent, may be the toast of the evolving economic order. But declaring them the new citadels of the world economy is a stretch and premature.

Although developing countries are projected to account for about three-quarters of global growth in 2007, their size is still too small to power the world economy. Take the four BRIC nations: Collectively their GDP amounted to $5.6 trillion at the end of 2006. That's 43 percent of U.S. GDP, 56 percent of the 13- nation euro area's and 130 percent of Japan's.

When it comes to stock markets, the gap is even wider. The aggregate free-float value of the Brazilian, Russian, Indian and Chinese stock markets is a mere 4.9 percent of world market value, according to Morgan Stanley Capital International. The four BRICs are 12 percent of the U.S. market value, 16 percent of Europe's and 56 percent of Japan's.

China's CSI 300 Index has more than tripled in the past 12 months. Still, the country's stock market represents just 1.9 percent of total world-market value compared with U.S. equities' global share of 42 percent.

Even though developing countries are trying to boost domestic demand, they remain dependent on exports, accounting for about 45 percent of the world's cross-border sale of goods, according to Merrill Lynch.

Furthermore, the Japanese and German economies -- respectively, the world's second- and third-biggest -- are slowing, adding to the woes of emerging-market exporters already thumped by weaker U.S. growth. Japanese GDP fell an annualized 1.2 percent in the second quarter, and there's a good chance the ruling Liberal Democratic Party, eager to remain in power, will backslide on promised fiscal changes.

Meanwhile, Germany suffers from sluggish consumption, a strong euro that threatens exports, and a credit crisis that will increase the cost of financing investment.

No doubt, developing countries have come a long way since the 1997-1998 Asian financial crisis and the Russian default in 1998. Back then, Asian countries were starved for cash; now emerging-market economies, led by Asia, account for 66 percent of global foreign-exchange reserves. Inflation is down. And many countries have adopted flexible currency regimes.

As a group, the countries' total external debt-to-GDP ratio has been falling since 2000. And the aggregate current-account surplus of 54 countries studied by Goldman Sachs rose to 4.7 percent of GDP in 2006. That compares with a deficit of 1.4 percent of GDP in 1995.

Nonetheless, ``there are still plenty of vulnerable economies in the emerging-market space,'' says Gray Newman, New York-based senior Latin America economist at Morgan Stanley. South Africa, Turkey, Hungary and the Czech Republic have run current-account deficits averaging more than 4 percent of GDP for three years, while Turkey, Poland, Hungary and India have posted fiscal deficits of 3 percent to 8 percent of GDP in the last three years.

What's more, ``before we ring in the decoupling era, it is worth recalling that it has not been tested with a U.S. economy in recession,'' Newman says.

Bottom line: ``The old saying, `If the U.S. sneezes, the rest of the world catches a cold,' remains relevant,'' said the International Monetary Fund in its April 2007 edition of the World Economic Outlook.

How much of a cold depends on how big the sneeze.

A Slide Show on SIVs and MLEC

Below is a link to a short slide show on the SIV business and the bank bail-out fund (MLEC). This is quick and very informative.

http://money.cnn.com/galleries/2007/news/0710/gallery.superfund/index.html

According to Ambrose Evans-Pritchard The Sky Has Fallen

Ambrose Evans-Pritchard is one of my favorite authors. He writes well and has a great sense of humor, except recently it is not always evident. Truth be told, recently he seems a little panicked. Below is an article of his in the UK Telegraph that gives a good summary of the credit markets, actions of the central banks, housing market, etc. It is always nice to get a point of view from outside the US.

By the way, Ambrose thinks things are going “to hell in a hand basket” fairly soon. So sit back, relax, and read on to enjoy good writing and some interesting conclusions. Text in bold is my emphasis.

If you are a bear, you must accept that you will always be wrong in polite society, and you will continue to be wrong all the way down to the bottom of recession. That is the cross that bears must bear.

Over the last three months we have seen a rolling collapse of speculative debt and real estate across half the global economy, yet friends still come over to my desk at the Telegraph, with that maddening look of commiseration on their faces, and jab: “so when is the sky going to fall then, eh”?

Well, excuse me. The sky has fallen. The median price of US houses has crashed from a peak of $262,600 in March to $211,700 in September. This is an 18pc drop nationwide.

Yes, the year-on-year slide is still just 4.2pc, but that will soon change as the base effect catches up.

Merrill Lynch has just confessed to a $7.9bn write down on CDO subprime debt and assorted follies, nearly double what it suggested three weeks ago.

This is what happens when a bank values its CDO debt at “mark-to-market” rather than “mark-to-myth”, as some of Merrill’s rivals are still trying to do.

Merrill’s Q3 loss of $3.5bn has cut the group’s equity capital by a fifth. This has consequences. The bank’s lending multiples will have to shrink.

In Britain, we have had the first bank run since the City of Glasgow Bank collapsed in 1878. The Fed has cut the interest rates a half point and vastly increased the pool of eligible collateral for Discount operations. The European Central Bank has injected over €400bn of liquidity in the biggest intervention since the euro was created.

Japan is in recession. Housing starts fell 23.4pc in July and 43.4pc in August.

The US dollar has fallen below parity with the Canadian Loonie for the first time since 1976, and to all-time lows on the global dollar index.

All it will take now for a full-fledged rout is a move by the Saudi and Gulf states to break their dollar pegs, which they may have to do to prevent imported US inflation causing havoc; or for the Asian banks stop buying US Treasuries – as Vietnam, Singapore, Korea, and Taiwan, have gingerly begun to do.

And for good measure, the Bank of England has just warned in its Financial Stability Report that lenders are still in serious trouble, that there is a risk of commercial property crash, and that equities are “particularly vulnerable” to a downturn. It is said there may well be a repeat of the summer crisis, “potentially on an even larger scale.”

What more do you want?

It is true that stock markets have once again decoupled from the realities of the debt markets. But they did this in the early summer, when the Bear Stearns debacle was already well under way. They caught up famously in August.

Nobody I talk to in the City credit trenches believes for one moment that the crunch is safely over. Indeed, they think that we are edging back to extreme stress levels, and the longer it goes on, the worse the damage.

Yes, Blue Chip companies can borrow money, but most of them don’t need to do so because they have bloated cash reserves.

Once you go down the chain, the picture changes fast. The iTraxx Crossover index measuring spreads on mid to low-grade corporate debt has jumped 100 basis points or so in the last week to around 360. It costs companies 1.8pc more to borrow than it did in the halcyon days of the credit bubble in February, if they can borrow at all.

The ABX indexes measuring subprime debt – those infamous CDO packages of mortgages sliced and diced, and sold to German pension funds and Japanese insurers with a lot of lipstick -- are still falling to record lows.

As Goldman Sachs strategist Peter Berezin put it: “It’s the summer that won’t end,”

“We continue to learn that it pays to respect the sell-offs in ABX and housing-related credit. This has elements of the February and August sell-offs, where credit markets signalled problems,” he said.

From a par of 100, these indexes have fallen to (depending on the vintage):
AAA grade: 90
AA: 64
A 33
BBB 21

This means that the toxic BBB tier has lost almost four fifths of its value. Even the AA has lost a third.

Now, remember that the total stock of subprime and Alt-A (close kin) debt issued from early 2005 to early 2007 amounts to $2 trillion. Ben Bernanke’s estimate that losses would be $100bn looks wildly optimistic.

Not to labour the point, but three-month Euribor rates are still at 62 basis points over the ECB’s 4pc rate. This amounts to a de facto half point rise since the crunch for all those in the euro-zone with floating mortgage rates – 98pc of the total in Spain, the biggest property bubble of them all.

Asset-backed security (ABS) issuance peaked at €78bn in March, fell to €52bn in July, €9.8bn in August, €5.6bn in September, and €2.5bn in October. It has died. Banks no longer dare to hawk the stuff of fear of a humiliating rebuff.

As for asset-backed commercial paper in the US, it has contracted every week since August as the lenders refuse to roll over short-term loans. Roughly 25pc of the market has been closed down, cutting off almost $300bn of funding for SIVs.

These SIVs (structured investment vehicles) are `conduits’ – in City argot – that allow banks to juice profits by speculating off books on high-risk debt. They borrow short (three to six months) to invest long (five years of so), making money on the interest arbitrage. Until the game blows up, of course. By the way, if you are like me you had to look up the word argot (pronounced ar-go): it is basically the special vocabulary and idiom of a particular profession or social group.

Some $370bn still needs to be rolled over, and there lies the rub. The strong suspicion is that Hank Paulson’s $75bn SIV rescue for the big four US banks is intended to cover up the problem by feeding out losses slowly, rather than allowing firesales to cause a cascade.

As the Bank of England warned, the Super-Siv should not be used to prop up fictitious valuations.

“It stinks, as does the Treasury’s sponsorship of the scheme. It seems designed to prevent price discovery.”” says Bernard Connolly, global strategist for Banque AIG.

Connolly says it resembles the slippery practices at the start of the Bear Stearns debacle, when creditors quickly abandoned attempts to force CDO sales by the Bear Stearns hedge funds as soon as they realized that prices were collapsing – exposing the awful truth that hundreds of billions were falsely valued on books.

Nauseating though Paulson’s MLEV -- `Master Liquidity Enhancement Conduit’ – may be, it probably has to be done.

Connolly says the Fed-led pack of central banks have made such a mess of capitalism by blowing credit bubbles (with low rates in the late 1990s and 2003-2006) that they now have no alternative other than to relaunch the “Ponzi Scheme”, or risk depression.

This will have political consequences, of course. “The looming threat on the horizon, or just over it, is that the socialization of risk will be accompanied, in many countries, by the socialization of wealth,” he said.

Indeed. The investors now baying for bail-outs had better be careful what they wish for. Democracy will have its way of making them pay. One recalls the 98pc tax rate on dividends in Britain in the late 1970s. Haircut now, or haircut later.

In any case, the Paulson Super-Siv has failed to calm the horses. “This rescue has back-fired. The central banks don’t want anything to do with it. There is a fear that the big four US banks are trying to hide their debts,” said Hans Redeker, currency chief at BNP Paribas.

The DOW is down 500 points or so since peaking in early October, and it looks wobbly.
Even so, equities have not begun to reflect the reality that the 2006-2007 credit bubble has popped and cannot be easily reflated at a time of stubborn, lingering inflation. Spare me the mantra that the “fundamentals” are sound. Credit is the ultimate fundamental.

Woe betide Wall Street if the Fed fails to slash rates dramatically over the Winter, starting on October 31.

Woe betide the dollar if it does.

Home Ownership Rate Declines For The Fourth Consecutive Quarter

The excerpts below from a article is Bloomberg states that the percentage of people owning homes has declined from a high of 69.3% in 2004 to 68.1% in Q3 2007. The percentage of people owning homes 10 years ago was about 64%. This is also the longest decline since 1981. The article also contains additional comments about the housing market, none of which is rosy. Text in bold is my emphasis.

The proportion of households that own their residences fell to 68.1 percent in the July-September period from 68.3 percent in the prior three months, according to a report today from the Census Bureau in Washington. The rate has been declining from a peak in 2004, which culminated a decade of gains fueled by easier lending standards and rising home purchases by immigrants and younger households.

``Owning a home in this country has been a principal source of wealth creation for low- and moderate-income people,'' said Nicolas Retsinas, director of Harvard University's Joint Center for Housing Studies in Cambridge, Massachusetts. ``In the absence of home equity, families will inevitably spend less.''

Homeowners accumulate wealth faster than renters, with median net wealth for owners at $184,400 in 2004, compared with only $4,000 for renters, according to Federal Reserve figures.

The ownership rate reached a record 69.3 percent of households in 2004, up from 64 percent a decade earlier. With home prices soaring, net household wealth nearly doubled to $51.8 trillion at the end of 2005 from $27.6 trillion in 1995, with real-estate accounting for 47 percent of the change, according to Federal Reserve data.

A September study by the Fed Bank of Atlanta found that as much as 70 percent of the increase in the aggregate homeownership rate over the decade was due to the introduction of new mortgage products, including second mortgages. Demographics, including the rapidly growing immigrant population, accounted for up to 31 percent of the increase, said the study.

Now, declining ownership rates mean fewer Americans will be able to tap housing equity to fund education, vacations and other spending. In the last year, the proportion of American households that own their homes dropped by 0.8 percentage point, the biggest year-over-year decline since 1981-82.

The U.S. entered a recession in July 1981 that lasted until November 1982, according to the National Bureau of Economic Research, which tracks business cycles.

The Census Bureau report also found that a record 17.9 million U.S. homes stood empty in the third quarter as lenders took possession of a growing number of properties in foreclosure. The figure is a 7.8 percent gain from a year ago, when 16.6 million properties were vacant, the Census Bureau said. About 2.07 million empty homes were for sale, compared with 1.94 million a year earlier, the report said.

``If homeownership declines significantly, the implications for new-home sales could be dramatic,'' said Hatzius. With further weakness in sales, ``the drag from new-home building on GDP growth will last longer than most people have in their forecasts, perhaps, if things go badly, into 2009.''

Housing starts, which track work begun on new homes, fell 48 percent to a 1.19 million annual pace in September from a three-decade peak of 2.29 million in January 2006. Sales of new homes declined 45 percent to an annual pace of 770,000 units in September from a peak of 1.389 million in July 2005.

With inventories of unsold homes piling up near record levels, housing prices will have to fall further, economists say.

Home prices in 20 U.S. metropolitan areas dropped 3.9 percent in July from a year earlier, the biggest such decline since record-keeping began in 2001, according to the S&P/Case- Shiller home-price index.

Goldman Sachs is forecasting a 15 percent decline in home prices from the peak to trough, Hatzius said.

Second mortgages, along with interest-only, payment-option and other unconventional mortgage products, have largely dried up this year as subprime defaults mounted and lenders such as American Home Mortgage Investment Corp. closed their doors. That makes it harder for people to refinance adjustable-rate loans before they reset at higher rates.

``So many mortgages with ARMS are resetting and most people can't make their payments,'' said Steve Hawkins, a real-estate agent at Re/Max Inc. in Alexandria, Virginia. ``And with the new criteria, they can't get loans'' to refinance their mortgages, he said.

The volume of mortgages issued this year will fall to the lowest since 2000, the Mortgage Bankers Association forecast on Oct. 17. Foreclosures doubled in September from a year earlier, RealtyTrac Inc. said Oct. 11.

There Will Not Be a Recession, But Here Are All Reasons Why There Could Be a Recession

This all sounds like double speak from Michael Boskin, but it is actually quite informative. But you do have to read between the lines. Text in bold is my emphasis. From Market Watch:

Despite severe problems in the housing market, a credit crunch and record-high oil prices, the U.S. economy will skirt a recession in the coming few quarters and get back on a solid growth path after that, economist Michael Boskin told real estate industry executives Thursday at the Urban Land Institute fall conference.

Boskin, a senior fellow at the Hoover Institution at Stanford University and former chairman of the Council of Economic Advisers under the first President Bush, told 6,700 members of ULI that the U.S. economy is clearly slowing, although GDP growth will stay positive.

However, there is a risk that something worse could transpire, especially if housing prices spiral downward, Boskin said.

"There are a lot of headwinds for the economy housing, autos, oil. And we don't have a lot of shock absorbers left," he said. "So anybody who doesn't have a Plan B (for their business) should get one." I assuming that everyone has a "Plan B".

Boskin said job growth, while not booming, remains on a steady pace and that unemployment near 4.5% means the U.S. economy remains near "something that resembles full employment." And he said that households have added significantly to their net worth in the last few years, not through payroll savings but through asset growth in housing and the stock market. The housing net worth is probably illiquid at this time.

"Savings look OK as long as asset values hold up. And unless there is a large download of asset values, household balance sheets are in good shape," he said.

The key trouble spot is home prices, which have been falling in many markets and are likely to show an overall national decline this year and next of 2% or so.

"But if home prices stabilize, most people will still have more home value than they did three or four years ago. Homeowners don't 'mark to market' immediately," he said, and so are unlikely to look upon small declines in home values as a problem for their overall financial position.

Boskin's longer-term outlook for the U.S. economy is "cautiously optimistic," he said, with the U.S. in as good a long-term position as economies in Japan, the rest of the Asian region and Latin America, and decidedly in better shape than Europe, which he said benefited from a "golden era" in global growth in the last three years but which has a pessimistic long-term outlook. What is the issue with Europe?

It Is 11 am. Do You Know Where Your Money Is? SIVs and Money Market Accounts

The excerpts below from an article in CNNMoney.com may not be the way to start your weekend. If you thought your money was safe in your money market account, maybe it is not. Apparently some money markets accounts hold SIVs. The complete article has companies (or funds) that have SIVs in their money market funds and some that do not. In my mind there is no excuse for a money market account holding SIVs. People are in money market accounts for the safety not the yield. Text in bold is my emphasis.

Money market funds are often the safest investments offered by fund companies, but several large money market funds own securities that were issued by structured investment vehicles (SIVs), the large, offshore funds that have recently made it into the headlines because the U.S. Treasury, along with Citibank, B of A, and JP Morgan Chase are working on a plan to shore up them up.

Typically, SIVs borrowed money by issuing short-term notes at a certain interest rate and then invested that money in longer-term securities that had higher interest rates, hoping to make money on the difference between interest rates. Many money market funds bought the notes that SIVs issued to raise the money to make their bet.

Securities regulations state that money market funds can only buy short-term, very safe securities. In particular, rule 2a-7, part of the Investment Company Act of 1940, says that money market funds can only hold securities that have "minimal credit risks."

The fact that the SIVs are in trouble suggests that SIV securities had more than "minimal credit risks." Of course, money market funds would have felt comfortable buying SIV securities because they had very high credit ratings, but the current SIV difficulties indicate that those top-notch ratings were in many cases undeserved.

The issue here is whether money market funds should ever have been invested in SIV paper at all. . . . . certain money market funds chose to eschew SIV securities, which dispenses with the excuse that SIV exposure is an industry-wide phenomenon. Not everyone was into it.

If a fund company was doing its job, it would have asked itself very seriously whether the SIV notes deserved to be in a money market fund. Specifically, they'd go about enquiring whether SIV securities met the requirement of rule 2a-7 -- that they didn't present anything more than the minimal credit risks.

The argument for the defense of money market funds holding SIV paper goes something like the following. The SIVs that issue the notes are highly rated, well managed and have high quality balance sheets. Recently, they have been hit, almost unfairly, by an extraordinary panic in the credit markets that has led to a drop in demand for the notes the SIVs issue to fund themselves. And once the markets get back to normal, especially with the help of the Treasury, the SIVs will be fine.

Why isn't this approach convincing? Remember the key test is whether the securities present minimal credit risk. In this case, we have to ask whether the SIVs were actually strong enough to deserve the AAA rating, which usually only applies to entities with tiny amounts of credit risk.

That rating on a SIV implies that the SIV has the strength to get through almost any crisis. The fact the SIVs stumbled so quickly shows that they weren't built with anywhere near enough capital or commitments of back-up funding.

Fund management companies should have looked beyond the rating and basically asked themselves: Does a SIV really have the same creditworthiness as U.S. Treasurys, also rated AAA? And they should also have noted how skewed the SIVs were to short-term funding, since that is a common mistake in investing.

The other defense argument is that the SIV notes are backed with assets, which means the holders won't take a big loss because they have a claim on those assets and the income they produce. This is true, and it is a source of comfort for any poor money market funds holding SIV paper that does go into a liquidation process.

But it'd be a stronger argument if the SIVs had actually made public what the assets are that back their paper. What if those assets were loans or securities that are themselves distressed or very hard to sell? If so, the holder of the SIV securities will end up getting back less than 100 cents on the dollar.

But if a money market fund were to recoup the value of its SIV securities by claiming the underlying assets, wouldn't that allow the fund company to say that the SIV securities had "minimal credit risks" after all? Are you crazy?

Money market funds are supposed to the safest fund investments of all. They're not supposed to get involved in liquidations. That sort of event is a nightmare for a money market fund. And indeed it will be a nightmare if it does turn out that fund management companies have failed to follow rule 2a-7.

The Three Ingredients That Will Lead to a Recession

The excerpts below from an article in the WSJ give the three reasons why the US economy will slide into a recession. I really like his three rules in trying to forecast a recession. Text in bold is my emphasis.

It was basically a triple whammy: Housing prices kept falling, oil prices kept rising and both lenders and borrowers grew more cautious after five years of incaution. The combination was simply too much even for the impressively resilient U.S. economy. The Federal Reserve saw it coming, but couldn't move swiftly enough. Still, Fed Chairman Ben Bernanke's interest-rate cuts helped keep the recession as short and mild as those of 1990-91 and 2001.

There are three rules to keep in mind when reading a recession prediction.

• Rule No. 1: Forecasters rarely call the turn in the economy accurately. Even the wisest business-cycle veterans have a hard time. "There are forecasts of thunderstorms and everyone is saying, 'Well, the thunder has occurred and the lightning has occurred and it's raining.' But nobody has stuck his hand out the window," then-Fed Chairman Alan Greenspan told Fed colleagues on Oct. 2, 1990, transcripts reveal. "And at the moment," he said, "it isn't raining. ...The economy has not yet slipped into a recession." Much later, arbiters at the private National Bureau of Economic Research determined a recession had begun that July.

• Rule No. 2: Once forecasters start shaving their growth forecasts, they tend to keep shaving them. At the end of August, economists surveyed by Macroeconomic Advisers, a St. Louis forecaster, predicted the U.S. would grow at a 2.7% annual rate in the fourth quarter; last week, they were betting on 1.6% growth.

• Rule No. 3: There are always good reasons to argue, "This time it'll be different." But "this time" is usually different in specifics, not in the overall outcome. (In my opinion the five most dangerous words in the English language are: it is different this time.)

The housing story is painfully clear. A June WSJ.com survey found that by a 3-to-1 ratio economists thought the worst of the housing bust was behind us. They were wrong. Housing kept sinking. Housing starts in September were 26% below year-earlier levels. That's a direct hit to economic growth.

Falling housing prices are a second hit. The price of the median existing home sold in September was down 4.2% from a year earlier. That is reducing household wealth, shaking confidence and increasing foreclosures. That's significant because today's recessions are triggered more by collapsing asset prices -- the bursting tech-stock bubble in 2001, for instance -- than by the old cycle of retailers and factories reacting to rising inventories of unsold goods by curtailing orders and production. (This is an interesting idea.)
"Only twice have we had this kind of housing collapse without a recession, in 1951 and 1967, and both times the Department of Defense came to the rescue, because of the Korean War and the Vietnam War," Edward Leamer of the University of California, Los Angeles, told the Federal Reserve's Jackson Hole, Wyo., conference in August. Mr. Leamer and his UCLA forecasting team say this time will be different. They predict "a near-recession experience," but expect factories, aided by export orders, to avoid recession-inducing layoffs. (see rule #2)

The energy story is less clear. Oil and gasoline prices are up and look likely to keep rising. That has hurt, but not crippled, consumer spending on other things. But oil at nearly $90 a barrel -- $30 higher than at the start of the year -- doesn't seem to have had much impact on global economic growth yet. There's good reason for that: Oil prices are up partly because China's growth spurt increases its appetite for oil. You can't have a recession because you have too much demand. And inflation-fearing central banks haven't panicked and raised interest rates in response to higher oil prices, as they once did.

But that was yesterday's story. If oil prices keep climbing because producers can't or won't increase supply or because of recurrent tensions in the Middle East, the effects are unlikely to be as benign. The next $10 increase in oil could hurt consumers more than the last $10 increase.

And then there's the prospect of a credit crunch, the consequence of lenders and investors being burned by mortgages and other loans that turned out to be much riskier than anticipated. As the late economist Rudiger Dornbusch used to say: "The crisis takes a much longer time coming than you think and then it happens much faster than you would have thought." Rudi was right.

Commercial banks, investment banks and the market itself are tightening lending terms. That may, as central bankers argue, be a welcome reaction to excessively generous lending in years past. But coming on top of housing and energy, the understandable desire of lenders to be a bit more tight-fisted is likely to turn what might have been painfully slow growth into recession.

Now, recall Rule No. 1. What could prove me wrong? Mr. Bernanke talks hopefully about a "two-speed economy" in which housing remains weak and the rest of economy remains strong. After all, the best guesses are that the U.S. grew at significantly better than a 3% annual rate in the quarter ended Sept. 30. The continued boost to U.S. exports from a weakening dollar and continued economic vitality in Europe and Asia could yet offset the triple whammy. But global growth prospects, except for China, look gloomier than six months ago. And, at home, the job market could continue to be strong enough to give consumers the wherewithal to keep spending.
But that's not the story I expect to be writing in October 2008.

The CDO Market and Associated Losses For Some Large Financial Institutions

The charts and tables below are from an article in the WSJ discussing the $8.4B loss that Merrill Lynch is going to take in Q3. The first chart gives the CDO volume since 2000 for both Merrill Lynch and the entire industry. The table gives the trading losses and asset write downs that each financial institution is going to take in Q3. It should be noted that additional losses may have to be taken in future quarters. The financial institutions are just beginning to get a handle on the losses they have before them. In addition as the housing market deteriorates additional losses will surface. (Double click to enlarge.)

Assuming some addition is correct the entire CDO market since 2000 has totalled $1.3523T (that is T as in trillion).

The data for this table comes from the print version of the WSJ.

The Tough Reality of the Housing Market

The excerpts bleow are from an article in the WSJ and address some of the tough realities of the current housing market. The article has additional information about specific markets and also a table of some basic housing metrics on 28 metro areas. Text in bold is my emphasis.

. . . . . a severe tightening of credit by mortgage lenders is keeping many buyers out of the market, while the huge supplies of homes for sale have persuaded others that they can wait for further price cuts.

Meanwhile, The Wall Street Journal's quarterly survey of housing-market conditions in 28 major U.S. metropolitan areas shows that inventories of unsold homes are still rising in most of them, prices are generally falling and overdue loan payments are piling up.

Some forecasters now warn that home prices are unlikely to start rising in most of the country before 2009 or 2010. A year ago, many home builders and lenders still thought that the housing boom -- which more than doubled prices in some areas during the first half of this decade -- would end with a gentle landing. Now those hopes are dead.

Home lenders have been growing more cautious for more than a year. But they suddenly tightened the screws much more in August, when investors grew so alarmed about rising defaults that most wouldn't buy loans other than those guaranteed by Fannie Mae or Freddie Mac or insured by the Federal Housing Administration. That led to a brutal drop in both lending and home sales.

Even so, home sales are likely to remain weak for months because lenders are still very cautious and huge supplies of homes are weighing on prices. On a national basis, the number of previously owned homes listed for sale is enough to last about 10.5 months at the current sales rate, the NAR said. The supply of detached single-family homes, at 10.2 months, is the highest since February 1988. Supplies hovered around four to five months for the first half of this decade. When the figure is longer than six months, it is considered a buyer's market.

Inventory figures reported by Realtors probably understate supply because not all foreclosed homes are sold through real-estate agents, says Doug Duncan, chief economist at the Mortgage Bankers Association. Another issue that has not (and cannot be measured) is shadow supply, that is the number of homes that would like to sell, but are not on the market because the owner knows they will not move.

The better news for sellers is that the number of homes on the market is no longer rising as fast.
House prices, as measured by the S&P/Case-Shiller national index, are likely to fall about 7% this year and a similar amount in 2008, says Jan Hatzius, chief U.S. economist at Goldman Sachs in New York. He believes a further small decline is likely in 2009. Of course, house-price movements vary greatly around the country and even within metro areas; in some desirable locations with limited supply, prices are likely to keep rising.

Thomas Lawler, a housing economist in Vienna, Va., believes prices generally should stabilize in 2009 at around 15% below their mid-2006 peak. After that, he sees them reverting to their long-term trend of rising slightly faster than inflation. The fast increases of earlier in the decade were an anomaly, fueled largely by lax lending standards, Mr. Lawler says, and the current housing slump is persisting because "multiple years of excess tend to take multiple years to correct."

What Moves the Market?

Excerpts from an article in the WSJ caught my eye this morning because I often wonder what moves the market. If some person comes up with a rumor no matter how unreasonable, that person can move the market. What if the market is down for the day, which is ruining some trader’s position, does that person float a rumor in the hopes of moving the market up. Sounds to me like the market is at the whim of unscrupulous random rumors, that people just make up in the hopes of improving their positions. So much for the efficient market hypothesis. Hmmm! Text in bold is my emphasis.

Lingering concerns about corporate earnings, credit risk and the economy sent stocks plummeting, only to stage a furious afternoon comeback amid hopes for lower interest rates.
The Dow Jones Industrial Average was off more than 200 points at its intraday low, but it ended the session off just 0.98 point, or 0.01%, at 13675.25. The Dow is up 9.7% this year.

Safety-seeking investors drove up prices of government securities, driving down their yields. By late afternoon, Treasurys maturing in five years or less were yielding less than 4% for the first time in more than two years.

Rumors of an emergency meeting of the Federal Reserve helped to drive the afternoon rally in stocks. A spokesman for the central bank declined to comment. Experienced Fed watchers considered it extremely unlikely, as Fed rate-setters already have a regularly scheduled meeting next week. . . . .

. . . . . "People naively believed we were out of the woods," said A.G. Edwards & Sons strategist Bill Hornbarger. "Now that we're getting a second dose of it, they're thinking this is not going to go away -- and it's going to have negative implications for the larger economy."

Thomas di Galoma, head of U.S. Treasury trading at Jefferies & Co., said the market now clearly expects Fed to cut its short-term interest-rate target when it meets beginning Tuesday.

Futures traders, he notes, are now pricing in roughly an 80% chance of a half-point cut by the end of the year, up from a 40% chance two weeks ago. (I heard this morning on CNBC that it is up close to 100%.)

New Home Sales Are Up In September, But Are Things Really Improving?

According to the US Dept. of Commerce as reported by Market Watch new home sales are up in September compared to August, however, the new home sales reported in the previous three months were revised downward. Before everyone gets excited about a turnaround in the housing market new home sales only represents about 15% of the total home sales market and the sale of existing homes was down significantly in September (see previous post from yesterday). In addition, new home sales are down 23% from the same time last year. So you can take comfort in the fact that not much has changed in the last few months, the housing market continues to crash and we are moving into the slow time of the year. Text in bold is my emphasis and if its in color that means I think it is of special interest.

Sales increased 4.8% to a seasonally adjusted annual rate of 770,000 from a revised 735,000 in August, an 11-year low. Previously, August's sales had been reported at a 795,000 pace.

The three previous months were revised sharply lower, which means the housing market was much weaker in the middle of the year than previous believed, and no one believed it was strong.

"The crash continues," wrote Ian Shepherdson, chief economist for High Frequency Economics. Sales fell at a 35% annualized pace in the third quarter, he said.

The large revisions highlight the low confidence that government statisticians have in the monthly report and the frequent large revisions it undergoes. Longer trends do a better job of showing the reality of the housing market than volatile monthly numbers.

Sales of new homes are down 23.3% in the past year. The sales figures do not account for canceled sales contracts, which have surged in recent months, especially since the seizing up of some mortgage markets. Many buyers are unable to find financing at the rate they want.

Inventories of new homes on the market fell 1.5% to 523,000, representing an 8.3-month supply, down from 9 months in August. The inventory of completed homes continued to rise, however, new construction on single-family homes has plunged 31% in the past year, according to a separate report released earlier.

Sales rose in two of four regions in September, with sales in the West rising 38% after a 23% drop in August. Sales fell 19.5% in the Midwest to the slowest pace in 16 years. Sales dropped 6.6% in the Northeast and were essentially flat in the South, rising 0.5%.

The government cautions that its housing data are subject to large sampling and other statistical errors. Large revisions are common. The standard error of 10.3% is so high, in fact, that the government cannot be sure in most months whether sales rose or fell. (Over time additional information is obtained to reduce the standard error and revise the final sales number.)

It can take up to five months for a trend in sales to emerge. New-home sales have averaged 806,000 per month over the past five months, compared with 833,000 in the five months ending in August.

Home builders have piled on incentives, including offering free vacations and new cars, to sell homes and reduce inventories. Such incentives are not subtracted from the sales price reported to the government.

Sales are reported when a contract is signed, not at the closing of the sale. Home builders have reported a large increase in cancellations in recent months, with some builders reporting that 50% of orders are cancelled. Cancellations are not reflected in the government data, so the reported sales are likely overstated, and inventories are unstated (should this be understated).

Why the Dollar Will Continue to Decline

The article below from the WSJ is a well-reasoned argument for why the US dollar will continue to decline for some time to come. Test in bold is my emphasis.

Nearly every day in recent weeks seems to bring news that the dollar has fallen to record lows against the euro and other major currencies. Important factors include the Fed's bold -- but appropriate -- 50 basis-point cuts in the Federal Funds rate and the discount rate, and the policies we are likely to see in coming months from the European Central Bank and the Bank of England.

But to really understand the dollar's future prospects, we must view its recent decline in the broader context of events over the past decade.

As the nearby chart shows, since 2001 there have three distinct phases of what I have called the dollar downdraft. From 2001 though the spring of 2004, there was a trend decline in the dollar against the currencies of other major countries. This occurred during an initially sluggish U.S. recovery and an aggressive ease in Fed policy that drove the fed funds rate down to 1% and kept it there for a considerable period.

In 2004, as the U.S. expansion was robust, productivity growth remained strong, and the Fed began hiking interest rates to normalize policy "at a measured pace," the dollar downdraft was put on hold. During this period from June 2004 (the first Fed hike) to August of 2006 (the first Fed pause), the dollar was in a trading range, neither trending up nor down, a fact that surprised a market consensus going into 2005 that a dollar fall for that year was inevitable.

The fact that the dollar appreciated for most of 2005 illustrates that in a world of increasing global capital market integration, in which the dollar remains the global reserve currency, strong U.S. growth and rate hikes that keep U.S. inflation expectations anchored provide important support for the dollar. Also, the dollar still serves as a safe haven in periods of global economic and financial stress, as occurred in September 2001 and August 2007, to name just two examples.

Since the August 2006 meeting, at which the Fed announced at least a pause if not an end to the interest-rate hike cycle, the dollar downdraft has resumed. There are several reasons for this, and these reasons suggest the dollar downdraft is likely to continue for some time to come. First, the U.S. economy in the second half of 2006 slipped into what has now been more than a year of below-trend growth. Moreover, this occurred in the context of buoyant global growth, not only in the developing world, but also in Europe, Canada and Asia.

This relative U.S. underperformance is likely to continue, as the economy works through the headwinds of the housing contraction and consumer retrenchment in the face of tighter credit conditions and a soft labor market. But a U.S. recession is not necessarily in the cards, in large part because the Fed will probably ease more in future months to provide insurance against an economic contraction.

The U.S. economy will be moving toward a narrower trade deficit for some time to come. It appears as though the trade deficit has peaked, and it starting to decline as a result of slower U.S. growth, a robust global economy, and a weaker dollar. Indeed, all of the increase in the trade deficit between 2004 and 2006 was due to higher oil prices. The non-oil trade deficit has been more or less constant since 2004, and is now starting to show clear evidence of decline.
As the U.S. economy moves from being an engine of global growth to a path that is in line with the average of other major countries, the trade deficit will narrow and a weaker dollar will be part of that adjustment. This adjustment need not be inflationary.

Currencies can depreciate because of bad monetary policy, as was the case for the U.S. in the 1970s. But they can also depreciate with sound monetary policy if currency adjustment is called for -- as it is now -- to rebalance the domestic and global economies as the U.S. trade deficit shrinks.

The world financial system is undergoing an evolution, as economies from Asia to the Middle East to Europe allow more flexibility in their exchange rates and/or peg them against a basket of currencies and not just the dollar.

Reserve diversification will continue, and sovereign wealth funds will likely invest across a broader range of assets than reserve managers do at present. All of these developments will keep the dollar downdraft going for some time.

A U.S. inflation surge is not likely, although the Fed will face upward pressures on inflation from sources that were not so prominent until recent years -- a possible slowdown in productivity growth and booming commodity prices, as well as the weaker dollar.

But ultimately the U.S. inflation rate will be up to the Fed. At present, with core inflation measures within the Fed comfort zone, and payrolls contracting, the Fed is now rightly focused on cutting interest rates to preempt a U.S. recession.

Buffet Comments on Housing and the Value of the Dollar

The excerpts below from CNNMoney.com are some general comments about the US economy from Warren Buffet. People are always looking for stock tips from Warren Buffet. His comments about the economy are very useful because they give an over view of the economy than can then be used to find stocks (if you like stocks). Personally, his comments are better at steering people into mutual funds. For example, he expects the US economy to remain weak and the dollar to continue to weaken. The investment strategy could be mutual funds that invest outside the US and any mutual fund that is a play against the dollar (energy and gold).

American billionaire investor Warren Buffett said Thursday that problems in the U.S. subprime mortgage market will likely weigh on consumers for up to two years, but that the U.S. economy will weather the storm.

Rising default rates among U.S. mortgage holders with poor credit histories have rattled global credit, stock and currency markets since August and raised concerns about a possible recession in the U.S. economy, a major export market for Asian companies.

"In the next 6 months, one year, two years the problems in the mortgage market can cause a lot of problems with consumers and hurt buying power in the United States," he said at a press conference after arriving earlier in the day from China on his private jet.

However, the U.S. economy has often had to face various difficulties and the present was no exception, Buffett said.

"Overall the economy will make progress," he said.

Buffett also expressed pessimism on the U.S. dollar.

"We still are negative on the dollar relative to most major currencies," he said.

The dollar has fallen against the euro, British pound, Japanese yen, Indian rupee and many other Asian and European currencies this year. The euro, for example, has gained 8 percent against the dollar this year.

Chinese Economy Expanded 11.5% in Q3

The purpose of the excerpts below from an article in Market Watch, is to give people a feel for the amazing growth of the Chinese economy. The Chinese economy is a tremendous growth engine that is busy developing its infrastructure. The real risk to this growth is an economic slowdown in the US, because it is an export driven economy.

China's economy, the biggest contributor to global growth, expanded 11.5 percent in the third quarter, . . . . . compared with an 11.9 percent gain in the second quarter, the fastest pace in 12 years.

A record trade surplus helped drive a 26.4 percent surge in factory and property spending in the first nine months, . . . ``

The government confirmed today that inflation cooled in September to 6.2 percent from an almost 11-year high of 6.5 percent in the previous month after food-price gains slowed.

``The surging economy has stabilized, while rising prices have been brought under control through a combination of monetary, fiscal policies and administrative measures,'' said Li Xiaochao, the statistics bureau spokesman. Oil prices, the U.S. housing recession and weaker U.S. consumption pose uncertainties, he said.

The pace of consumer-price gains was still more than double the central bank's annual target of 3 percent and higher than the key one-year deposit rate of 3.87 percent, encouraging stock and property speculation.

Urban fixed-asset investment growth is outpacing the 24.5 percent gain for all of 2006. Investment accounted for 42 percent of GDP expansion in the first nine months, versus the 37 percent share for domestic consumption, the statistics bureau said. External demand made up 21 percent. Industrial production increased 18.9 percent in September from a year earlier, the fastest pace in three months and up from 17.5 percent in August, the government said. Retail sales climbed 17 percent after gaining 17.1 percent.

China's taken six years to achieve 40 percent of a 20-year target of quadrupling per-capita GDP by 2020, spokesman Li said, citing an increase to 16,084 yuan this year.

A 69 percent surge in the trade surplus in the first nine months to $185.7 billion has flooded the economy with cash. It's also prompted calls by U.S. Treasury Secretary Henry Paulson and the Group of Seven nations for a stronger Chinese currency, which would ease trade tensions and the inflow of money by making exports more expensive.

A report circulated last week within the National Development and Reform Commission, China's top economic planning agency, called for a 15 percent to 20 percent one-off revaluation, Market News reported yesterday.

The yuan has climbed more than 10 percent versus the U.S. currency since the end of a fixed exchange rate in July 2005 and fallen 7 percent against the euro.

For China, a slowdown ``may expose a severe overcapacity problem, leading to excessive inventory, unemployment, a pile-up of non-performing loans and sharp declines in corporate earnings,'' said Sun Mingchun, an economist at Lehman Brothers Holdings Inc. in Hong Kong. ``The government needs to add investment restrictions and boost consumption.''

Just in Case You Were Wondering Why the Price of Oil Keeps Going Up

Just in case you were wondering why the price of oil keeps going up - certainly one of the reasons is the growing demand for oil in Asia. Admittedly, the price of oil is also increasing because of the drop in the value of the dollar, but increasing demand is a major factor. As an aside, I continue to be amazed at the growth of the Asian economies. From the WSJ:

Galloping growth in Asia, led by China, was one of the key reasons global oil prices started shooting up in 2004. . . . .

Since then, governments in the region have initiated projects to cut back on oil consumption. . . . .

But many of the efforts have been thwarted by faster-than-expected growth and by the reluctance of governments to take unpopular steps to push up the cost of using fuel and rein in demand. Moreover, much of Asia's oil demand is driven by transportation needs, making it difficult to alleviate with alternatives such as coal or nuclear power.

Asian demand for oil is on track to hit 25 million barrels a day this year, an increase of 2.5% from last year, according to the International Energy Agency in Paris. World demand is set to rise a more modest 1.5% and may even decline in Europe. (The U.S. -- which is on pace to consume 20.9 million barrels a day this year, up less than 1% from last year -- remains the world's single largest consumer.)

Several countries, including China and India, continue to subsidize consumer fuel costs and in some cases have cut gas-station prices this year as oil prices have surged. Such moves help shield everyday users from the swings of global oil markets but also discourage them from cutting back when global prices rise.

The recent decline in the value of the U.S. dollar -- and parallel rise in the value of some Asian currencies -- has also given Asian consumers more power to spend liberally on fuels, because oil is typically priced in dollars and therefore cheaper to buy. . . . .

. . . . Asian governments are also becoming more ambivalent about crop-based alternative fuels such as ethanol and biodiesel, which are made with agricultural commodities, including corn and palm oil. Prices for such crops have soared in recent years, and many governments no longer want to promote fuels that use agricultural commodities because they fear it will cause broader food-price inflation and harm low-income consumers.

Officials in China and elsewhere remain keenly aware of the dangers that high oil prices pose to their economies. Asia must burn more fuel to generate economic growth than the West, primarily because it is more reliant on energy-intensive industries like heavy manufacturing than other parts of the world.

But Asia held up well when oil prices first jumped in 2004, and many Asian governments, including China, have huge cash reserves on hand to bail out their economies if oil prices keep climbing. The Asian Development Bank recently raised its estimates for 2007 growth in Asia excluding Japan to 8.3% from 7.6% in an earlier forecast.

Maybe OPEC Does Not Have the Power It Used To Have

Excerpts below from a WSJ article discuss the waning ability of OPEC to control the price of oil like it has in the past. A cost of “Peak Oil”?

Oil prices are hovering near historic highs, but consuming nations shouldn't expect quick relief from OPEC, the world's only source for big, quick supplies.

For several reasons, the Organization of Petroleum Exporting Countries has neither the clear leverage nor the inclination to open the spigots and drive down the price of crude, which jumped past $90 a barrel in intraday trading in New York last week for the first time. . . .

. . . . OPEC officials insist that geopolitical jitters and speculative cash are driving the price surge, not a crimp in supply. Any step to boost output would come on top of the cartel's decision last month to add about 500,000 barrels a day to world supplies as of Nov. 1, a move that did little to calm the market.

The cartel, which satisfies nearly 40% of the world's demand of 86 million barrels of crude a day, is estimated to have slightly more than two million barrels a day in spare capacity, nearly all of it in Saudi Arabia.

Using a large share of that capacity now would erode the ability of major oil-producing countries to intervene later if prices surge even further.

OPEC and its de facto leader, Saudi Arabia, have fought for more than a year to reassert the group's ability to modulate oil-price swings. But the thin margin between the world's strained supplies and growing demand results in wide price swings in both directions. Saudi Arabia's ability to influence markets also is hampered by a lag of as long as three months before new supplies hit markets.

Last autumn, with prices hovering around $60 a barrel, OPEC ministers agreed to cut output by 1.2 million barrels a day, or about 4%, to try to drain off what they saw as overly large international oil inventories.

The cartel agreed to a second cut, of 500,000 barrels a day, in December. But oil prices responded by falling abruptly in January to near $50 a barrel, their lowest level since mid-2005.

Prices have gyrated in the past 15 months despite OPEC's moves to calibrate production, hitting a then-high of $77.03 a barrel in July 2006, then falling early this year before climbing again. Late last week, the price of oil settled at $89.47, setting a record. At the close of trade on the New York Mercantile Exchange . . . . .

The turmoil has revived a longstanding debate over whether OPEC has any real ability to calibrate a market that has grown infinitely more complex since the cartel's heyday in the mid-1970s. "OPEC has become more a responder to events than a mover of events," says Joseph Stanislaw, an energy adviser at Deloitte & Touche USA LLP. "OPEC can promise but it can't always deliver."

OPEC officials and ministers have expressed similar exasperation in recent days, arguing that the price surge had nothing to do with the one lever they command. "The market is very well-supplied," OPEC Secretary-General Abdalla Salem El-Badri said in a statement last week. Rising oil prices, he said, were "largely being driven by market speculators," though he cited refinery bottlenecks, the falling U.S. dollar and geopolitical jitters as other factors. . . . .

Another Good Summary of the SIV Market – Now the Concern is Timing

Excerpts below from a WSJ article discuss some of the basics of the SIV market and whether or not the bank bail-out (MLEC) will arrive in time. Stay tuned, this is a good one to be a spectator at, especially if you really want to see how things are handled under stress. Text in bold is my emphasis.

As three of the world's biggest banks try to finalize a rescue plan for some shaky investment funds, the funds themselves face mounting problems.

The outlines of a new superfund -- an effort led by Citigroup Inc., Bank of America Corp. and J.P. Morgan Chase & Co. that may include at least seven other banks -- are still being hashed out, according to a person familiar with the situation. The three banks could present a formal structure to potential bank partners and funds as soon as next week.

Meanwhile, the funds at the heart of the situation -- known as structured investment vehicles, or SIVs -- need to find investors for $100 billion in debt coming due in the next six to nine months, even as ratings firms continue to come out with reports that lower the ratings of securities in moves that could further depress the value of SIV holdings.

SIVs sell short-term debt and then use the proceeds to buy longer-term, higher-yielding securities. But SIVs have had trouble in recent months selling debt, and some of their roughly $350 billion in assets are backed by U.S. mortgages -- a market that has seized up amid the housing slump and subprime-lending shakeout. Typically, money-market funds, municipalities and other risk-averse investors buy SIV debt.

The bank consortium would provide much-needed cash to the funds by setting up a superfund to buy highly rated securities from them. The superfund plan would aim to buy assets from the SIVs to prevent them from selling those assets en masse at today's depressed prices, something the banks and some regulators say could roil markets and the economy.

The plan, which the banks aim to finalize by month's end, could still fail or arrive too late to be of help. Besides tapping the superfund, SIVs are likely to restructure their debt, wind down or, in a worst-case scenario, become a dead SIV that can't pay debt investors.

Still, as the superfund negotiations continue, problems for SIV operators have worsened. Some SIV operators, such as Citigroup and Rabobank of the Netherlands, have been selling assets. In the United Kingdom, the Whistlejacket Capital Ltd. fund operated by Standard Chartered PLC is considering alternative funding plans, a Standard Chartered spokesman said.

Meanwhile, the types of assets held by some SIVs continue to come into question. Moody's Investors Service Inc. recently downgraded $33.4 billion of securities issued in 2006 and backed by subprime mortgages in moves that could make it more difficult for SIVs to unload assets.

Holders of SIV capital notes are bearing the brunt of the SIV fallout. Investors in capital notes typically supply an SIV with as much as 5% of its money. In return, these noteholders -- often European banks and insurers -- receive a share of the SIV's profits or losses. They are ranked lower than the other debtholders and thus could be the first to bear losses if SIVs sell assets to the banks' rescue fund.

Capital-notes holders face two options: risk losing money if the SIV sells assets to the banks' fund at a loss, or try to keep the SIV going by buying more of its debt. In recent days, SIVs have been trying to persuade capital-notes holders to buy medium-term notes to fund the SIVs and protect their investments, people familiar with the matter say. Some capital-notes holders -- and SIVs -- say they are skeptical about the banks' plan, because selling assets at today's prices will require the SIV and the notes holders to recognize a loss on those investments.

Capital-notes holders "profit if the SIV does well, but they lose their investment if there is a shortfall," says Geoff Fuller, an attorney at London firm Allen & Overy LLP, who advises clients including Citigroup on SIVs and other securitization projects.

U.K. mortgage lender Nationwide Building Society, for instance, recently invested a fraction of its assets in capital notes of several older, bank-sponsored SIVs, and says its holdings haven't been downgraded by ratings firms. Indeed, holders of notes in the shakier SIVs launched over the past two to three years, not those in older SIVs, are taking the worst lumps.

"We saw it as a potentially attractive risk-reward proposition," says Mark Hedges, Nationwide's head of structured finance. "We are monitoring the situation because it needs to be monitored, but we have a very modest portfolio."

Mr. Hedges, like other notes holders, says he is concerned the rescue fund could dilute the value of his investment. He adds he doesn't have enough information to make up his mind on the fund.

The lead banks have provided little public guidance on their plans for the fund, leaving themselves open to criticism. Executives working on the fund see it not as a silver bullet but as one of several options open to SIV operators, according to a person familiar with the effort. The plan would benefit a lead participant, Citigroup, because it is a large operator of SIVs. The SIV industry has become a key part of the U.S. economy, because the funds buy securities backed by mortgage loans to U.S. home buyers. The industry, at its peak earlier this year, totaled about 30 funds with $400 billion in assets.

The three banks have many issues to work out, according to people familiar with the situation. They need to figure out how participating banks would divide any profits or shoulder losses when the rescue fund is wound down, according to people familiar with the plan. They need to decide if participating banks will be ranked based on how much funding they provide, just as banks take lead and supporting roles in stock offerings.

In recent days, the group has tried to bring in other banks. Wachovia Corp. plans to participate -- at a level likely below the three lead banks -- pending approval of a governance plan for the fund, said a person familiar with the situation. Germany's Dresdner Kleinwort, a unit of Allianz SE and operator of the K2 Corp. SIV, and Britain's HSBC Holdings PLC, the affiliate of the Cullinan Finance Ltd. SIV, are considering joining. Both are large SIV operators.

Another “Realistic” View of the Housing Market

Below is another, what I consider, realistic view of the housing market. Being an optimist or a pessimist about the housing market is not the issue. The issue about the housing market is to be a realist. Thank goodness the financial press is beginning to state where we are at. My dad used to tell me, "you can't get to some place unless you know where you are at". Text in bold is my emphasis. From Market Watch:

The housing market is just getting worse. Home resales tumbled 8% in September to the lowest levels in this decade, prompting the obvious question: When will it all end?

The honest answer is no one knows. Optimists have been saying for more than a year that the worst is behind us, while the pessimists have been saying recovery is still a year, or years, away.

So far, the pessimists have been right about the weakness in the housing market, but their forecast that the collapse in housing would lead to a general economic malaise has, at least so far, failed to pan out. The economy has slowed, but has not fallen into recession, as consumers and investors adjust to a world in which home prices don't automatically rise 5% or 10% a year.

The only thing that's clear now is that the housing market has gotten worse since the spring. The market was in a free fall in September. Sales of existing home fell 8%, while inventories of unsold homes rose to a 10.5-month supply. It could take 320 days for a home to sell.

Sales of existing single-family homes are down 20% in the past year, the fastest decline in 16 years.

Median prices have dropped 4% in the past year, in part because fewer expensive homes are being sold, but also because the typical home is worth less than it was a year ago.

Homes are only worth what someone is willing to pay for them, and right now, most homes on the market have no buyer in sight. Prices may have to fall much more to bring supply and demand back into balance, economists say.

Builders have almost no confidence. The home builders' index fell to a record low in October (the index dates back to 1985). New construction on single-family homes has plunged 31% in the past year, but still the inventory of new homes on the market, after adjusting for cancellations, is at the highest level since the early 1990s.

As if the fundamental sickness in the housing market weren't enough, a secondary infection has developed. The credit crisis in the mortgage market that erupted in the summer has left huge numbers of potential buyers without any access to mortgages.

The subprime sector has essentially died, with the newly reinvigorated Federal Housing Administration able to replace only a tiny segment of what was once a huge market of home buyers.

The top end of the market was also frozen out, as jumbo loans (those with mortgages above the conforming level of $417,000) became more expensive or completely unavailable.

The jumbo freeze-out devastated sales in pricey areas such as the San Francisco Bay area, where jumbo loans had accounted for about 52% of purchases in August, but just 39% in September. There's some evidence that the jumbo market is slowly returning, but it's not functioning normally yet.

"We are seeing the first buds of spring" in the recovery of the jumbo market, said Stephen Stanley, chief economist for RBS Greenwich Capital. "It's a slow, glacial recovery."

Historically, housing corrections take a long time. After the market softened in the late 1980s, sales fell for five years, then took three more years to return to the peak level. Prices took just as long to recover.

Some analysts say the fundamentals will worsen in coming months. The main problem is that so many adjustable-rate mortgages will reset to a higher interest rate. The typical family with an ARM will see mortgage payments rise by $10,000 a year, according to Andrew Jakabovics of the Center for American Progress, a progressive Washington think tank.

Millions of these home owners will be unable to refinance their current loan and will either have to scrounge to make the payments, or lose their home through a fire sale or foreclosure. That would throw even more supply onto a saturated market.

"The mortgage crisis is neither wholly contained nor likely to abate in the near future," said Jakabovics. "Default and foreclosure loom ever more menacingly as borrowers are unable to find a reasonable payment option and unable to sell their homes."

Economists are Beginning to Get Real About the State of the Housing Market

Finally, economists are beginning to get real about the condition of the housing markets. Admittedly, housing markets are local, but the housing market across the country is fairly weak. Text in bold is my emphasis. From CNNMoney.com:

The battered markets for real estate and home building still have farther to fall, according to a range of economists who spoke Wednesday at a forecast conference sponsored by the National Association of Home Builders.

The economists agreed that the problems with home finance markets will continue to hit housing into next year, and that even when there is a recovery, it will be a slow process that will see weakness continue into 2009.

While most said they believed the overall U.S. economy can weather the housing downturn, several saw significant risk of a recession. Mark Zandi, chief economist of Moody's Economy.com, said that large areas of the country will fall into recession, if they haven't done so already.

The economists also admitted to being surprised by how bad the housing downturn has become, and all said that making forecasts of a recovery is difficult due to the problems in the credit markets.

"This time, we just don't know how it's going to pan out because the securities markets have become so much more important," said David Seiders, chief economist with the builder's trade group.

Zandi estimated that the excess inventory of homes on the market is close to one million, and he added that the glut could get worse if mortgage defaults and foreclosures increase, as it now appears they will.

"We're awash in inventory," he said. "I don't think this [credit] crisis is over. It's less stark than it was four to eight weeks ago. But I wouldn't be surprised if the embers which are smolder catch on fire again."

Thomas Lawler, a former Fannie Mae official who is now a private housing and finance consultant, said the easy financing terms of the boom years have been replaced by an overly restrictive lending environment. But even when underwriting standards return to more normal conditions, it won't be enough to lift demand and prices back to peak levels, he added.

"There's a part of the mortgage market that is gone for at least a while, and it should be because it should never have been there," Lawler said. "But that will slash demand. If the pace of building doesn't continue to fall, we'll see even worse price declines." He's now projecting prices down another 6 or 7 percent next year, on top of declines of that amount this year.

"The fact that building wasn't cut as early as it should have been is one of the reasons that that prices continue to fall," he said.

Still, Michael Moran of Daiwa Securities said he puts the chance of a recession at only about 30 percent, as employment and income should stop the housing market from going into a free fall.
And Bernard Markstein, a National Association of Home Builders economist, said that the fact that home building isn't seen as coming back to 2005 levels or even 2006 levels for the foreseeable future isn't a bad thing.

"The real comparison should be to 2002 to 2003, back when we were meeting our needs, not to 2004 or 2005," Markstein said. "That's when we were overbuilding - we don't want to be there."

The Big Bank Bail-Out Plan or MLEC – What Are They Really Trying to Accomplish?

The excerpts below from an article in the WSJ, discusses the SIV bail out being put together by three big banks. This is an excellent summary of what the banks are trying to accomplish, the risks involved. One point I would like to add to this post that the article did not include is that in the conduit business in which the banks partook, the banks would often agree to cover the corporations commercial paper if the commercial paper could not be rolled-over. There in lies the real rub. If they can't roll-over the commercial paper then the bank has to cover it. But, who said the large banks were altruistic. See a previous post on conduits, this provides good background information. Text in bold is my emphasis.

When Lee Iacocca ran Chrysler in the 1980s, he complained about a double standard for enterprises in trouble.

Ailing industrial companies got no sympathy, he said. Economic Darwinists urged them to make drastic cutbacks or even perish, in the name of market discipline. And it took many months of struggle before Chrysler got U.S. loan guarantees. When banks stumbled, it was a different story -- no matter how foolish their mistakes. They were rescued in the name of protecting the global financial system.

Several of the world's biggest banks are going through strange gyrations to avoid owning up to missteps in the London market for structured investment vehicles. SIVs are funds the banks set up as a way to make money without taking the risks involved onto their balance sheets.

The banks have dropped hints that if they don't succeed in raising a $75 billion rescue fund, dangerous ripples could spread into the broader commercial-paper market and beyond.
Such talk roused the U.S. Treasury earlier this month to help Citigroup Inc., B of A, and JP Morgan Chase draft the rescue plan. The big banks are proposing a fund that would buy troubled SIV assets, helping liquidate mortgage-related investments that otherwise might be dumped on the market at a loss. The government isn't putting money into the plan, but its role could be crucial in persuading investors to buy debt issued by the rescue fund as part of the plan.

For all the drama of late-night rescue talks, though, the banks have danced around two crucial questions. First, is the SIV market so important to world economic health that it should be saved in its own right? Second, are global markets in such perilous shape that a shakeout in SIVs could trigger collapses in other capital markets?

It's hard to say "yes" to either question. SIVs exist mostly as a way for banks to do business without putting up their own capital. The market hardly existed 15 years ago; today, its total assets amount to $350 billion.

There's nothing special about how SIVs invest their money. They own the usual assortment of bank debt, mortgages and other asset-backed instruments. What's striking is how they are set up, with huge amounts of leverage on a slim capital base; with bank sponsors that don't own them but instead collect management fees for running them; and with their funding derived mostly from short-term commercial paper.

Put those three factors together, and it's clear that SIVs can make tidy profits for banks when things go well. But they are vulnerable to a liquidity squeeze if the commercial-paper market dries up. That's what happened this summer.

Even Citigroup, one of the most active SIV sponsors, isn't portraying these conduits as the bankers' equivalent of the eight essential amino acids, without which we can't live. In a research report last month, Citigroup analyst Birgit Specht wrote that it's too early to tell whether all such conduits will survive. Regulatory changes are dimming the appeal of conduits, to the point that banks may revert to traditional balance-sheet placement for many such holdings.

So if SIVs aren't vital per se, do we still risk Armageddon if they fade away too quickly? Anyone familiar with the Depression-era wave of bank failures has to be mindful of the risks that panics can spread, crippling sound institutions.

But this time around, banks world-wide are in remarkably robust health. For the first few years after the September 2001 terrorist attacks, interest-rate trends made almost any lending profitable. Their trading desks have done just fine in recent years. And most corporate clients have been models of good behavior.

If banks ever could absorb a few hits, now is the time. Current conditions differ sharply from 1982, when the Latin American debt crisis hit as major U.S. banks were struggling with a recession and the aftermath of lofty short-term rates that squeezed lending margins. In 1982, regulators had good reason to worry about a domino chain of defaults. There's more padding in the system today.

Hasty rescue plans amount to an amnesty for sloppy banking and an invitation for it to continue. Japan's experience in the 1990s is a case in point. Rather than owning up to banks' poor judgment in real-estate lending, Japanese authorities tried for years to shore up shaky loan portfolios. That produced economic stagnation.

Even worse, painless rescues protect the careers of bankers who ought to pay the price for their poor judgment. So far, no CEO of a major U.S. bank has been held accountable for the SIV mess. There haven't even been any widespread purges of their lieutenants.

People involved in the SIV rescue fund say it will buy troubled funds' holdings at prices that both shore up the market and are economically rational. Hmmn. It was fascinating to hear Alan Greenspan, former Federal Reserve chairman, weigh in last Friday with doubts about how investors would feel if "some form of artificial non-market force is propping up the market." But if the SIV rescue fund tries too hard to make prices levitate, that's just throwing good money after bad.

Existing Home Sales Drops 8% From the Same Time Last Year

The housing slump continues to deteriorate as is to be expected. Both the sales of existing homes and the prices are down in September. The excerpts below are from the original National Association of Realtors (NAR) press release. Included are the footnotes in case you are interested in getting seeing how the calculations are made. Also here is a link to the spreadsheet with the that is included with the press release in case you are a numbers person.

There is not much to say about these numbers other than the trend continues with no bottom in sight.

Existing home sales including single-family, townhomes, condominiums and co-ops – fell 8.0 percent to a seasonally adjusted annual rate1 of 5.04 million units in September from a downwardly revised pace of 5.48 million in August, and are 19.1 percent below the 6.23 million-unit level in September 2006.

The third quarter finished better than expected, with a 5.42 million annual rate of existing-home sales versus the 5.38 million forecast by NAR.

The national median existing-home price2 for all housing types was $211,700 in September, down 4.2 percent from September 2006 when the median was $220,900; this follows three months of stability in comparing with year-ago prices. The median is a typical market price where half of the homes sold for more and half sold for less.

“Because there were fewer transactions at the upper end of the market, there is a downward distortion reflected in a lower national median home price. Home prices continue to trend up in the Northeast and in the condo sector. In other areas not dependent on jumbo loans, such as much of the Midwest, prices are rising.”

Total housing inventory inched up 0.4 percent at the end of September to 4.40 million existing homes available for sale, which represents a 10.5-month supply at the current sales pace, up from a downwardly revised 9.6-month supply in August. “It appears raw inventories are stabilizing, but the housing supply is a bit inflated now because the sales pace does not reflect underlying market conditions – sales were dampened by the mortgage cancellations,” Yun explained. “Once the pent-up demand begins to move, we’ll see housing supplies begin to ease and then prices will edge up.”

According to Freddie Mac, the national average commitment rate for a 30-year, conventional, fixed-rate mortgage fell to 6.38 percent in September from 6.57 percent in August; the rate was 6.40 percent in September 2006.

Single-family home sales dropped 8.6 percent to a seasonally adjusted annual rate of 4.38 million in September from a pace of 4.79 million in August, and are 19.8 percent below 5.46 million-unit pace in September 2006. The median existing single-family home price was $210,200 in September, down 4.9 percent from a year ago.

Existing condominium and co-op sales fell 4.3 percent to a seasonally adjusted annual rate of 660,000 units in September from 690,000 in August, and are 14.7 percent below the 774,000-unit level in September 2006. The median existing condo price4 was $221,700 in September, up 1.4 percent from a year ago.

Regionally, existing-home sales in the South declined 6.0 percent in September to an annual pace of 2.05 million, and are 18.7 percent below a year ago. The median price in the South was $174,400, down 5.5 percent from September 2006.

In the Midwest, existing-home sales dropped 7.0 percent to an annual rate of 1.19 million in September, and are 16.2 percent below September 2006. The median price in the Midwest was $170,700, up 1.4 percent from a year ago.

Existing-home sales in the West fell 9.9 percent in September to a level of 910,000, and are 27.8 percent below a year ago. The median price in the West was $308,900, which is 8.8 percent lower than September 2006.

In the Northeast, existing home sales dropped 10.0 percent to a pace of 900,000, and are 13.5 percent lower than September 2006. The median price in the Northeast was $261,700, up 0.5 percent from a year ago.

Footnotes

1. The annual rate for a particular month represents what the total number of actual sales for a year would be if the relative pace for that month were maintained for 12 consecutive months. Seasonally adjusted annual rates are used in reporting monthly data to factor out seasonal variations in resale activity. For example, home sales volume is normally higher in the summer than in the winter, primarily because of differences in the weather and family buying patterns. However, seasonal factors cannot compensate for abnormal weather patterns. Existing-home sales, which include single-family, townhomes, condominiums and co-ops, are based on transaction closings. This differs from the U.S. Census Bureau’s series on new single-family home sales, which are based on contracts or the acceptance of a deposit. Because of these differences, it is not uncommon for each series to move in different directions in the same month. In addition, existing-home sales, which generally account for 85 percent of total home sales, are based on a much larger sample – nearly 40 percent of multiple listing service data each month – and typically are not subject to large prior-month revisions.

2. The only valid comparisons for median prices are with the same period a year earlier due to the seasonality in buying patterns. Month-to-month comparisons do not compensate for seasonal changes, especially for the timing of family buying patterns. Changes in the geographic composition of sales can distort median price data. Year-ago median and mean prices sometimes are revised in an automated process if more data is received than was originally reported.

3. Total inventory and month’s supply data are available back through 1999, while single-family inventory and month’s supply are available back to 1982. Comparisons of current total month’s supply with single-family data prior to 1999 are broadly valid because single-family homes accounted for more than nine out of 10 purchases in the earlier timeframe (e.g., condos were 9.5 percent of transactions in 1998, 8.5 percent in 1990 and only 6.1 percent in 1982).

4. Because there is a concentration of condos in high-cost metro areas, the national median condo price can be higher than the median single-family price. In a given market area, condos typically cost less than single-family homes.

Fed Official States That The Fed Must Shield The Economy From “High Cost” Events Such as A Worsening Housing Slump

This article in Bloomberg is interesting, because it is the first that I have seen the Fed state that there is a potential of worsening housing slump and that this would be a “high cost” event. Albeit, I don’t read everything the Fed says, but I do remember when just a few weeks ago the Fed was claiming that the housing slump was contained and not spilling over into other parts of the economy. It appears that in the analysis of the economy that the Fed does, they have run some deepening housing slump scenarios that don’t have “pretty” results. Everyone should expect this type of analysis the Fed is doing their “due diligence”. But, it is interesting they are talking about it.
Text in bold is my analysis.

Federal Reserve Bank of Chicago President Charles L. Evans said policy makers must shield the economy from ``high cost'' events such a worsening housing slump.

``I do not see this extreme outcome as likely,'' Evans said yesterday in his first speech on the economy as a policy maker. Still, ``it is one of those high cost outcomes that we should guard against,'' while closely monitoring inflation, he said at the University of Chicago's Graduate School of Business.

Evans, who votes on interest rates this year, stressed the importance of ``risk management'' in determining Fed policy and noted that ``uncertainty'' about the impact of financial volatility has increased in the past week. Traders anticipate the Fed will lower rates for a second time on Oct. 31, and Evans didn't rebuff those expectations.

``To me, the uncertainties about how financial conditions might evolve and affect the real economy mean that risk- management considerations have an important role in the current policy environment,'' said Evans, 49, who became president of the Chicago Fed on Sept. 1. Falling home sales and values may pose ``a more serious downside risk to growth'' than policy makers expect. Is this Fed speak for "recession"? (my comment)

Housing starts in the U.S. plunged more than forecast to a 14-year low in September, dropping 10.2 percent to an annual rate of 1.191 million from 1.327 million the prior month. Higher mortgage costs and stricter lending rules may further depress home sales and feed the decline in construction that threatens to stall economic growth.

The lack of job losses in construction has been ``surprising,'' Evans said in response to a question after the speech. While some workers fired from residential projects may have switched to commercial assignments, that explanation ``still seems unsatisfying,'' he said. Evans projected more firings in construction will take place.

The Fed lowered its benchmark interest rate by a half point to 4.75 percent on Sept. 18, the first cut in four years, to protect the U.S. from sinking into a recession sparked by fallout from the housing-market collapse. Trading in federal funds futures indicate an 86 percent chance of another cut, to 4.5 percent, when policy makers meet again next week.

Prices paid by U.S. consumers rose more than forecast in September as food and energy costs climbed, while the core measure that excludes those items showed inflation remains contained. ``Although I am optimistic about the chances for further inflation improvements, I would see any increase in inflation or inflation expectations from their current levels as a serious concern,'' Evans said. The central bank can't be ``lax on inflation front,'' and must carefully monitor both the outlook for prices and growth.

The U.S. economy expanded at the fastest pace in more than a year during the second quarter, before the sell-off in credit markets that threatens to hobble growth in the second half. Gross domestic product rose at a 3.8 percent annual rate from April though June, propelled by a surge in exports.

Since August, growth in five of the Fed's 12 regional districts has slowed, lending weight to the case for further interest-rate cuts to cushion the economy from housing and financial-market turmoil. Consumer spending, manufacturing and service industries weakened as the ``pace of growth decelerated'' across the U.S., the central bank said in its regional business survey last week.

Economic growth will be ``soft'' in coming months and recover later next year, moving closer to its potential rate of above 2.5 percent, Evans said. The Chicago Fed board was one of five regional bank boards that opposed the central bank's decision to lower the so-called discount rate by half a percentage point. The discount rate is the rate charged for direct loans to banks.

``Going forward, policy and the economic outlook have to be mindful'' about whether financial markets are functioning efficiently and effectively, Evans said in response to another audience question. ``Actions to date have been completely appropriate.''

The Fed Lends Its Support for MLEC (Citibank Bail-Out Fund)

Not exactly what I would call a “ringing endorsement”, but the Fed has indicated that it is supporting MLEC. It appears that the Fed is willing to support most “private-sector” proposals to help improve the liquidity of SIV market. Text in bold is my emphasis. From Bloomberg:

The Federal Reserve indicated it supports the plan brokered by Treasury Secretary Henry Paulson to increase liquidity in the market for asset-backed commercial paper.

The agreement reached by Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. is well-enough designed that it may help credit markets, a Fed official, who declined to be identified, said late yesterday in Washington. The plan also may help investors establish prices for complex securities that funds purchased with the proceeds of commercial-paper sales, the official said.

The Fed's endorsement comes as some banks, analysts and international officials question whether the planned $80 billion fund will help. Deutsche Bank AG Chief Executive Officer Josef Ackermann said yesterday that it is ``premature to make a firm judgment'' because details of the plan haven't been established.

Fed officials' silence since the agreement was announced Oct. 15 has been misinterpreted as criticism, the Fed official said.

Central bank policy makers have lowered their benchmark interest rate by half a percentage point and the charge for direct loans to banks by 1 percentage point since access to credit slumped in April. The New York Fed has also injected reserves into money markets to help provide liquidity.

The three biggest U.S. banks said last week that they would raise money for a fund that would buy assets from distressed structured-investment vehicles. Banks and hedge funds set up the SIVs to issue short-term debt and invest in longer-term assets such as bank loans and mortgage-backed securities.

Investor uncertainty about the value of complex assets held by the vehicles has damped willingness to lend to the funds in the commercial paper market, stoking concern they'll have to dump holdings at fire-sale prices. Two European-based SIVs, Cheyne Finance Plc and Rhinebridge Plc, defaulted on more than $7 billion last week.

Paulson kick-started the talks by having his top domestic finance official, Undersecretary Robert Steel, host meetings of bank executives at the Treasury in September. The Treasury chief told reporters on Oct. 19 that the department played ``a facilitating role.''

Both Paulson and Steel were able to draw on decades of experience in capital markets, as both are veterans of Goldman Sachs Group Inc. Paulson said he expected the fund to be set up by the end of the year.

Ackermann said yesterday that the plan would have to provide ``transparency'' to the prices of financial assets to succeed in restoring investor confidence. He spoke in Washington on behalf of the 31-member board of the Institute of International Finance, an industry association that represents the world's largest financial companies.

Some foreign officials have also expressed doubts. Mario Draghi, governor of the Bank of Italy, told reporters on Oct. 19 that ``there is still a lot of work to do before the fund works correctly.''
Treasury Assistant Secretary David Nason conceded as much yesterday, saying at a Washington conference that ``there are some details that will need to be worked on in the next few weeks. There is still work to be done.''

At the same event, Fed Governor Randall Kroszner said ``I have very much encouraged private-sector proposals,'' without commenting specifically on the SIV plan. ``I look forward to seeing how this'' evolves, he said.

What the Citibank, et al $80B Bail-Out Fund is Trying to Avoid

Below is an example of what the Citibank, B of A, and J P Morgan bail-out fund are trying to circumvent the default of a SIV. From Bloomberg:

Royal Bank of Scotland Group Plc is in talks to buy the assets of Cheyne Finance Plc, the structured investment vehicle that defaulted last week.

``The action follows detailed discussions with a number of different bidders over the past few weeks and after consultation with the informal creditors' committees,'' Cheyne Finance and its receiver Deloitte & Touche LLP said today in a statement.

Cheyne Finance appointed Deloitte last month to oversee its assets after the SIV was forced to liquidate some holdings to repay maturing commercial paper. The company, which bought securities backed by home loans, had its credit ratings cut to default by Standard & Poor's last week.

SIVs have sold about $75 billion of assets since July after record U.S. home foreclosures prompted investors to avoid debt linked to mortgages. The U.S. Treasury stepped in to arrange talks between Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. to create an $80 billion fund to buy the assets.

Cheyne Finance, set up by London-based hedge fund Cheyne Capital Management Ltd., has about $7.3 billion of outstanding debt, Standard & Poor's said on Oct. 19. The value of the portfolio backing Cheyne Finance's bonds is $6.2 billion, excluding cash of $948 million, S&P said.

More than half of Cheyne Finance's holdings are mortgage- backed securities, and have a market value of 93 percent of their face value, S&P said.

Deloitte is trying to organize a restructuring of the SIV's debt or the sale of its assets.

SIVs, with $320 billion of assets, invest in securities from mortgage-backed debt to bank bonds. They finance their investments by selling commercial paper, debt that comes due in 270 days or less, and medium term notes, which mature in nine months or longer.

Problems in the CDO and CLO Markets to Continue

The Fed Governor, Kroszner, states that the CDO and CLO derivative markets may take some time to resume their normal activity and even once they do the markets will more than likely look different then they did before. Text in bold is my emphasis. From Market Watch:

The markets from some complex derivatives remain broken and may recover only gradually, said Randall Kroszner, a governor of Federal Reserve Board on Monday.

"I would suggest that....the recovery may be a relatively gradual process and these markets may not look the same when they re-emerge," Kroszner said in a speech to the Institute of International Bankers.

Trading in some derivatives, such as collateralized loan obligations, or CLOs, and collateralized debt obligations, known as CDOs, has ground to a virtual halt since August.

Some of these structured credit products packaged pools of subprime mortgages loans.
As problems in the subprime mortgage market became more apparent over the summer, investors shunned these products and also became unwilling to purchase products that could have any exposure to housing-related assets and other structured products more generally.
Many investors had relied on credit rating agencies assessments of the products. A series of rapid downgrades helped investors lose confidence in the quality of the ratings.

Kroszner said these markets broke down because investors didn't do sufficient due diligence and the products were complex and opaque.

"Put simply, investors suddenly realized that they were much less informed than they originally thought," Kroszner said.

In the future, investors are going to have to invest heavily to understand these products and sellers will have to make them easier to understand, he said.

"As a result, it is likely that these markets and instruments will look different than they did prior to the recent market turmoil," Kroszner said.

Kroszner did not mention any role for regulators in the market. There is some concern that many of these derivatives remain on the balance sheet of banks or their conduits.

Kroszner said the Fed will be reviewing the lessons of the financial market turmoil.

Kroszner said that the Fed's actions to cut interest rates and boost liquidity had helped improve market functioning "though strains, particularly in term funding markets, persist even now," he said.

Market participants seem to expect that pressures in term funding markets will persist for several quarters as banks hoard cash. "In the months ahead, the Federal Reserve will continue to monitor developments in the financial markets and act as needed to support the effective functioning of these markets and to foster sustainable economic growth and price stability," Kroszner said.

The Weekend’s Contemplation – The Sovereign Wealth Fund – Clash of Capitalisms

Americans are consumed by the mortgage meltdown, the housing collapse, liquidity in the capital markets, etc. (or about Florida beating Kentucky, the Red Sox beating the Indians, etc.), but the biggest story of the century so far is playing out before their eyes – the Sovereign Wealth Fund (SWF). The US and western Europe has a type capitalism built on around the idea of relatively free markets with limited government involvement. Asian and Middle Eastern countries have the concept of capitalism built around free markets, but different from the US/European model, and much more involvement from the government. Two models of capitalism with different operating techniques. This should give you pause to think and better understand the implications of the SWFs. Two other things to consider: 1) what is the effect on the SWFs of the current turmoil in the capital markets. Do you think it hurts the reputation of the US and in fact is speeding the process by which other countries form relationships with one another. And 2) other countries (Canada comes to mind) are beginning to limit investment in their country by foreign interests. Should we be doing the same thing?

Text in bold is my emphasis. The original article is from Market Watch:

The government-run investment pools known as sovereign wealth funds aren't new, but they're growing fast, causing heartburn for politicians and policymakers and leading to calls for the funds and their government masters to clarify their practices and intentions.

The concerns were pushed into the headlines Friday when finance ministers from the Group of Seven industrialized nations sat down with representatives of some of the biggest funds to urge them to increase transparency and adopt a set of "best practices."

U.S. Treasury Secretary Henry Paulson said Saturday the G7 wants the International Monetary Fund to develop guidelines for the funds and argued that a set of best practices would help tamp down the potential for a protectionist backlash in countries where the funds invest.

"Best practices would provide multilateral guidance to new funds on how to make sound decisions on how to structure themselves, mitigate any potential systemic risk, and help demonstrate to critics that SWFs can be constructive, responsible participants in the international financial system," Paulson said.

Buoyed largely by growing oil profits and foreign exchange reserves, funds controlled by governments in the Middle East and Asia have grown rapidly in recent years.

Merrill Lynch, in a recent research paper, estimated sovereign funds now control around $1.9 trillion in assets. And they're growing fast, with the potential to surge to about $7.9 trillion by 2011, according to the report. Morgan Stanley estimated earlier this year that the funds could swell to $12 trillion by 2015.

Their current size exceeds the scope of the world's hedge funds, which are estimated to hold around $1.5 trillion in assets.

Based on this size comparison the SWFs are the new 900 pound gorilla. If you think the hedge funds were hard to regulate try the SWFs. (my comment)

No doubt, part of the nervousness surrounding the sovereign funds in the developed world stems from the potential for a political backlash against foreign-government ownership of major companies.

Nasser Al Shaali, CEO of the Dubai International Financial Center, acknowledged that the growing influence of sovereign funds from the developing world is "a bit unnerving for the powers that be."

But any effort to establish best practices shouldn't single out the sovereign funds, he said in a panel discussion Saturday hosted by the Institute of International Finance, but should apply to all forms of cross-border investment. Focusing only on the funds merely stirs up unfounded concerns about intent, Shaali said.

Some U.S. politicians squawked when China's recently launched State Foreign Exchange Investment Corp. bought non-controlling shares in private-equity giant Blackstone, and also quailed at government-owned Dubai Borse's acquisition of a stake in the Nasdaq stock market.

European Union officials had raised warning flags ahead of the G7 meeting, saying they fear some funds may aim to pursue political objectives rather than profits.

Such concerns were further underlined by former U.S. Treasury Secretary Larry Summers in a Financial Times op-ed earlier this year that questioned whether some funds would act in the same interests of traditional shareholders.

"The logic of the capitalist system depends on shareholders causing companies to act so as to maximize the value of their shares," Summers wrote. "It is far from obvious that this will, over time, be the only motivation of governments as shareholders. They may want to see their national companies compete effectively, or to extract technology or to achieve influence."

The is the primary but subtle difference in the capitalism models as practiced by the US/European nations and the nations of Asia and the Middle East. (my comments)

Others say worries are overblown.

Some of the biggest funds, including the Norwegian fund and Singapore's Temasek Holdings, routinely purchase non-controlling shares in enterprises -- a method that could serve as a solid model for some of the newer funds that have been stoking worries, said Roger Kubarych, chief economist at UniCredit.

At the same time, some large funds, including a Kuwaiti fund, often do take controlling shares and have shown themselves to be responsible stewards, he said.

But Edwin Truman, a senior fellow at the Peterson Institute for International Economics, argues that the establishment of best practices is in the interest of the countries that control the sovereign funds, ensuring that citizens know what is being done with their nation's wealth.

Moreover, it's important for the funds to attempt to get out in front of the issue, he said.
"Time is running out," Truman said in the IIF panel discussion. "The political calendar has a way of accelerating these things and SWFs are on the political agenda."

Truman has devised a scorecard that rates 32 of the world's largest funds according to a number of criteria, including structure, governance, transparency and accountability and behavior.

New Zealand's Superannuation Fund and Norway's global Government Pension Fund top the rankings, while the Government of Singapore Investment Corp., Qatar Investment Authority, and Abu Dhabi Investment Authority bring up the rear. (see scorecard)

Meanwhile, strategists are attempting to gauge how the funds' growing footprint will affect financial markets.

Merrill Lynch economists say the funds are likely to direct more money into riskier assets such as equities and corporate bonds, enhancing liquidity.

"Investors should rejoice in the more balanced global economy and the impetus that SWFs will provide to continued growth and development of global asset markets," said Alex Patelis, head of international economics at Merrill Lynch. "The impetus from these flows underpins continued growth of global asset markets, and the use of external managers should lessen what we see as overblown fears of protectionism."

The growing funds may also have implications for foreign exchange markets, said Stephen Jen, a London-based Morgan Stanly economist, in a research note Friday.

The "emergence and maturing" of the sovereign funds will likely help support non-G7 currencies and put pressure on both the U.S. dollar and the euro as the funds seek to diversify their foreign-exchange holdings, Jen said.

"It will not be a tug-of-war between the [dollar and the euro] anymore. [Emerging market] currencies and equities' impressive performance in recent weeks are consistent with this perspective on the SWFs," he wrote.

Paulson Defends the SIV Bail-Out Fund

Paulson defends the SIV bail-out fund being put together by a number of large banks from comments made by Greenspan. Text in bold is my emphasis. From Reuters:

U.S. Treasury Secretary Henry Paulson said on Friday a multi-billion-dollar credit rescue fund that big banks were setting up was purely market-driven and was not intended to help banks dispose of bad assets.

Paulson spoke to a few reporters after a news conference and was asked about criticism by former Federal Reserve Chairman Alan Greenspan, who said the fund might have "dire consequences" by delaying a necessary depreciation of the assets. Why is Greenspan making comments, I thought he was retired.

"This is market-driven and market-based," Paulson said. "The purpose of this...is not to buy bad assets or assets that have credit problems (but) for end-investors, working with the banks, to buy assets that aren't credit-impaired."

"That will accelerate the return to liquidity in parts of this market," Paulson said.

The investment pool is intended to acquire mortgage assets held by so-called Structured Investment Funds. Essentially , it is a bank-led "super fund" called Master Liquidity Enhancement Conduit, and it will resell the assets to investors.

In a published interview on Friday, Greenspan said the fund would increase the liquidity of those who had SIVs and effectively prop up the prices of distressed securities rather than allow them to fall as they should until bargain-hunters appear to buy them.

Paulson was evidently angered by Greenspan's criticism. He said Treasury's role in helping get it organized was only to facilitate it and emphasized that Treasury had been in frequent touch with the Federal Reserve and market participants in the process of doing so.

The fund will issue short-term notes to investors and use the proceeds to buy securities from SIVs that are going out of business. In that way, the assets can be resold but they are less likely to be sold at bargain-basement prices.

There are about 30 SIVs that have total assets valued at around $400 billion.

Paulson said that "under the best of circumstances it will take a good while for this master fund to be put together, documented...and to work." But he emphasized it is intended to function under market principles.

"All of us want the same thing, which is we want market forces to work and for it to be market-driven and to have market participants work together to accelerate a return to the liquidity that under the best of cases is going to be slow," Paulson said.

He said it will be "more valuable" if it is operating relatively soon and said he hoped it will be functioning before the year is over.

"Based upon my experience in doing complicated structures with multiple firms involved, it'll take a while but I think it should be do-able by the end of the year," Paulson said.

Greenspan suggested it would be best to let SIVs and banks bear the burden of holding bad assets by making them lower prices as much as necessary to sell them, rather than setting up a fund that some see as a bailout for the banks.

"If you intervene in the system, the vultures stay away," Greenspan commented. "The vultures sometimes are very useful."

An Important Psychological Barrier Falls, One More to Go

An important psychological price barrier for oil fell in after hours trading when November futures topped $90/barrel. There is only one barrier left - $100. What worries me most is that we have yet to see the crude oil increase at the pump, but if it is sustained we will see it in the grocery store either later this year or in Q1 2008. Also at what point do persistent oil related increases begin to stall the consumer spending? My guess is some where between $90 - $120. Text in bold is my emphasis. From Bloomberg:

Crude oil breached $90 a barrel in New York for the first time as the dollar traded near a record low against the euro, enhancing the appeal of commodities as an investment.

Investors purchased oil on speculation the Federal Reserve will cut borrowing costs to bolster the U.S. economy when policy makers meet on Oct. 31. Oil futures set records the past four days on concern supplies from northern Iraq may be disrupted if Turkey takes military action against Kurdish rebels.

Crude oil for November delivery rose to $90.07 a barrel in after-hours electronic trading on the New York Mercantile Exchange, the highest since trading began in 1983. Prices were up 53 cents on the day at $90 at 11:40 a.m. in London.

``The search for explaining the price development during this week leaves three elements outside the market fundamentals namely, the role of speculators, geopolitical developments in the Middle East and the weakness of the dollar,'' PVM analysts led by Johannes Benigni wrote in a report today.

The U.S. currency fell to $1.4302, from $1.4279 yesterday, and traded at a record low of $1.4319 earlier.

A lower dollar makes oil cheaper in countries that use other currencies. In U.S. dollars, West Texas Intermediate, the New York-traded crude-oil benchmark, is up 46 percent so far this year. Oil is up 35 percent in euros, 40 percent in British pounds and 42 percent in yen.

The Organization of Petroleum Exporting Countries, agreed last month to produce an extra 500,000 barrels a day starting on Nov. 1 to meet rising demand. World oil consumption peaks in the fourth quarter, when refiners make heating fuel for winter.

``Additional output from OPEC won't affect the market that's reacting to non-fundamental factors,'' Maizar Rahman, Indonesia's OPEC governor said in Jakarta today. ``The weakening U.S. dollar is prompting investors to move funds to commodities futures from currencies.''

The Basis for Markets Optimism

The article below is from Spiegel in Germany. The basic premise is that the optimism in the equity markets is the “hope” that the emerging markets can cover the weakness in the US for a while. What worries me is that most emerging markets are export based economies that are relatively small when compared to the US and western Europe. Text in bold is my emphasis.

With the US real estate and financial markets in turmoil, the optimism of stock brokers the world over seems a little out of place. There is, in fact, method to the apparent madness. But how sound is that method?

Stock brokers at the Frankfurt stock exchange are keeping a close eye on Germany's most important share index, the DAX. But have they lost sight of dangers lurking elsewhere?

Stock brokers are merrily celebrating the disaster at their doorstep: The turmoil caused by the US real estate crisis is estimated to have halved economic growth in the United States. The number of foreclosure sales has doubled within a year. And as if that wasn't enough, consumer morale has deteriorated dramatically in the last two months. The evil r-word -- recession -- has long been making the rounds among economists.

But the Dow Jones Industrial Average, still the world's most closely watched share index, reached the highest point in its 111-year history last Tuesday.

The situation is much the same in Germany: In light of the ongoing financial crisis, leading economists are tuning down their growth predictions, as is the federal government. The two most important early indicators of economic trends -- the Ifo index calculated by the Institute for Economic Research in Munich, and the index calculated by the Centre for European Economic Research in Mannheim -- have been dropping for four consecutive months. And the European Central Bank continues to inject billions and billions of euros into the financial system in order to prevent more near bankruptcies.

The most important German stock market index, the DAX, passed the 8,000 points mark last Thursday and remained just 1 percent below its all-time record.

Have stock brokers lost touch with reality? Are they once more in the grip of that optimistic and carefree mood that precedes every crash? Or are there in fact good reasons to be optimistic? "It's all a big test," says Thomas Mayer, Deutsche Bank's chief economist for Europe. "The financial markets are gambling on the possibility that the developing countries have matured."

Stock brokers are basing their calculations on the assumption that, for the first time in history, the emerging economic powers China, India, Russia and Brazil -- along with many developing countries whose economies are also growing rapidly -- are stabilizing the global financial system and global economic growth. Together, they are helping Western industrialized countries out of the fix they've gotten themselves into.

Until now, it was always the major North American and European economic powers that served as anchors for the global economy when major financial turmoil developed -- usually in Asia or South America. The insolvency of Ecuador (1999) and Argentina (2001) and the Mexican crisis (1994) -- but also the Asian and Russian crises (1997 and 1998) -- only caused minor dips in the temperature of the world economy.

Industrialized countries tempered the situation with debt conversion offers and financial injections -- neither of which were entirely selfless, of course. And they had a stabilizing effect thanks to their overwhelming economic output. A crisis in a developing country was no more than a minor spanner in the works of the Western-dominated economic machinery. But the importance of those countries has increased drastically since.

While the G-7 countries were still responsible for about 70 percent of global economic output in 1990, their current share has sunk to below 60 percent. The economic clout of developing countries is growing much faster. Moreover, the economies of those countries have become more stable, impressing observers with their steadily improving balance of account surpluses and shrinking budget deficits.

"These countries are much more resilient today than they were 10 years ago," says Heiner Flassbeck, who served as junior minister under the former German Finance Minister Oskar Lafontaine and who is currently the chief economist at the United Nations Conference on Trade and Development (UNCTAD).

All that is attracting Western investors hungry for returns. They are investing ever greater portions of their wealth in new financial centers such as Singapore, Seoul, Dubai, Sao Paolo and Cairo.

As a result, capital flows between the developed and developing worlds have also increased enormously. "When we started out 20 years ago, we had access to six markets. Now there are 40," says Mark Mobius, funds manager at Franklin Templeton and one of the first Westerners to invest in developing countries' stock exchanges.

Many investors now divert their assets to emerging markets and developing countries when the prospects at home look dim. In the week before last, more than $5.5 billion (€3.9 million) were channeled into emerging market funds. That capital provides additional fuel for economic growth and the boom those countries are already experiencing -- and economies in the industrialized countries profit from that as well. After all, industrialized countries supply cars and machinery and import cheap consumer goods. Orders are pouring in and trade is booming, all of which boosts share prices.

What a brave new world: Many believe that, thanks to globalization, every country profits from every other country -- a classic win-win situation in which there seem to be no losers. In such a scenario, why worry about a real estate crisis of limited regional scope that leads to a financial crisis whose effects are also limited to a particular region?

This kind of speculation can work for a quite a while. Indeed, most newly industrializing countries are hardly affected by the real estate crisis in the United States. The underlying economic data is genuinely reassuring. And it's true that industrializing countries have been bolstering the economies of industrialized countries for a while .

So, why cast doubt on the view that industrializing countries are stabilizing the economies of the industrialized countries? No reason in the short term, according to many economists. But others are striking a more cautionary note. In the midterm, China is especially at risk of being drawn into the vortex developing beyond the Atlantic.

After all, the Chinese economic boom is based on exports to the United States and other Western countries. Moreover, more than 45 percent of China's economic power goes into the somewhat erratic production of capital goods. Private consumption, which has become steadier, accounts for only 35 percent. That's a much riskier combination than was the case in Japan prior to its economic meltdown in the early 1990s. Add a banking system that is still vulnerable and overheated stock markets and there can be no doubt that the economy of the world's most populous country is more prone to crisis than tireless China-optimists like to believe.

If the United States should indeed slide into recession, as Yale University professor Robert Shiller and others predict, then China would be directly affected -- and with it, all of Asia. The other countries on the continent have long been exporting more to China than to the United States. China is the nerve center of an entire region -- and perhaps the entire world.

Critics are reminded of the brave new economic world of the late 1990s, when economists believed that crises had become a thing of the past. The creed of the time was that the productivity of the New Economy -- allegedly enormous -- had suspended the basic laws of economics, so that there could be sustained economic growth without inflation and therefore steadily rising share prices, of course.

That bubble burst shortly thereafter, in 2000.

"The Losses Have to Be Taken"

The quote above is from the article in Market Watch that discusses the bailout fund being set up by Citibank, JP Morgan and B of A and some of the associated problems. The article makes an important point the losses from the mortgage meltdown must be taken.

Having had a front row seat for the demise of Continental Bank in the mid-1980s and a bleacher seat for the S&L crisis of the early 1990s I can assure you that after everything is said the losses must be taken. Unfortunately, some institutions cannot take all the losses at one time, they can't afford it. So delaying tactics will be employed in the hopes that the losses can be taken over time so the institution can survive. Note one thing, losses are going to be taken for a while. Although the housing slump has been occurring in earnest since late 2006, the banks are just beginning to take losses in the third quarter, which means the losses need to catch up. I would note be surprised to see the banks taking losses on this portfolio through 2008. (Also I like the football in the house analogy. We used to do that when I was a kid, except we used to turn over the furniture too.) The text in bold is my emphasis.

Today's credit crisis has the feel of kids playing football in the house. Everyone is having a good time until the ball goes through the window.

It almost doesn't matter who threw the ball -- subprime borrowers or lenders, big banks, the leveraged-buyout guys, ratings agencies -- everyone was doing something they shouldn't have.

What's interesting is how all of the players are reacting. Some . . . . banks, who don't have these bad debts on the books, are pretending they don't need to clean it up.

and Treasury Secretary Henry Paulson, who may have left Goldman Sachs but still seems to live on Wall Street, are hell-bent on fixing the window.

These are the kids who think they can cover up the damage.

The fixers want to create up to a $100 billion fund to buy good assets from bad structured investment vehicles, or SIVs.

Here's one problem with this plan: If you follow the money, it doesn't make much sense. Start with a mortgage. It gets packaged by an investment bank into a collateralized debt obligation. That CDO is then sold to an SIV. The SIV is funded by a bank, investment bank or another industry lender. It could be the same bank through the whole process. At the minimum, it's a limited group of players.

Now, our original loan and others have gone bad, which means the CDOs have gone bad, which means the SIVs are in trouble. The industry's answer to this is to create yet another investment company to buy the good assets from the SIVs.

Detect a pattern?

Reaction to the plan has been lukewarm. Banks may be learning, just as the Fed did after its whopping rate cut last month, that it's hard to inject confidence into the market by panicking.

It's unlikely government or business leaders such as Paulson and Citigroup's Charles Prince would panic. It's even less likely Bank of America's Ken Lewis and J.P. Morgan's Jamie Dimon would rush in to prop up a competitor, since they didn't have much involvement in the SIV business.

That suggests there's a fire. Banks and other financial institutions, including Fidelity Investments, are reluctantly stepping forward in the effort even if they're in the camp that didn't set up SIVs or don't have a load of CDOs on the balance sheet. This mega-fund is not only the plan of the moment; it also appears to also be the best plan out there. Unfortunately, it won't stop the losses. Even if SIVs can fetch top dollar by selling good assets, the junk that was bought on borrowed money is still worthless.

"To properly solve the liquidity problem, the sponsors of the SIVs are still going to have to take losses," said Gerard Cassidy, an analyst with RBC Capital Markets. "To try to get out of this by papering over the losses is not going to work."

Analysts are becoming more convinced that the recent write-downs on Wall Street are the first in what will be a series of charges that banks will take during the next few quarters. Morgan Stanley's vice chairman suggested Monday that the profits made from the buyout boom will be washed away in the fallout.

The stakes are huge. There are 30 SIVs with $400 billion in assets. And even though asset-backed security issuance is down 17% from last year, underwriters have packaged 1,304 deals worth a combined $775.4 billion in 2007. CDOs, the danger piece of the pie, are about one-third, of that total, according to the research firm of Dealogic.

"We don't know how big it (the bad debt is)," Cassidy said, but it is clear some of "that stuff is toxic."

And does it matter who broke the window? Citigroup is the biggest issuer of asset-backed debt, with about a 9.5% market share. It's also estimated to have the most off-balance-sheet SIVs.
Going back to that broken window, the children have taken a deep breath. They have looked around the room. And in the calm, they realize there's broken things everywhere -- a vase, a hanging picture and spilled drinks. They stand before their mother.

"Some can't afford to take the losses," Cassidy said. "People can dicker over whether Paulson should have gotten involved or not, but the point is, they're trying to solve the problem with liquidity. Losses have to be taken."

The damage is done. Now everyone has to clean up, and someone has to pay.

The Fed Sees A Decelerating Economy

The most recent biege book indicates a decelerating economy. Text in bold is my emphasis. From Market Watch:

U.S. economic activity has slowed over the six weeks, according to the latest Beige Book report on current economic conditions released by the Federal Reserve on Wednesday.

Anecdotal reports from the 12 Fed districts "suggest economic activity continued to expand in all districts in September and early October but the pace of growth decelerated since August," the report concluded.

Five districts: Cleveland, Dallas, Kansas City, Richmond and San Francisco reported slower rates of growth. The other seven districts reported growth similar to the last report in early September.

The Beige Book is a series of anecdotal reports collected to help Fed officials prepare for their monetary policy meetings. The next meeting is set for Oct. 30 and 31. Economists are split on whether the Fed will cut interest rates further after the surprise half-a-percentage point rate cut on Sept. 18.

Federal Reserve Chairman Ben Bernanke has said that anecdotal reports are critical for Fed policymakers at the moment because government statistics are not timely enough to detect the impact of the financial turmoil on the real economy.

Uncertainty and unease seemed to be the two undertones of this report. The comments echo Bernanke's observation on Monday that the outlook for the U.S. economy remains "uncertain." "Contacts in a number of industries indicated a higher-than-usual degree of uncertainty about the outlook for economic activity," the survey found.

"At firms without direct ties to real estate and construction, contacts were still wary that credit tightening and slowing construction might slow activity in their industry," the report said.

Some reported cautious optimism because there was little evidence of a spillover from housing into other sectors at this time.

The debt crisis, which gained force in early August, was having a dampening impact on growth, the survey found. Banks, whose balance sheets are under pressure from their investment with derivatives based on subprime mortgages and asset-backed commercial paper, have responded by tightening credit standards, including for consumers and all types of real estate.

Home sales continued to fall.

"In some instances, buyers could no longer secure financing or were unable to sell their current homes," the survey said.

Retail sales were weaker and the store owners were worried about the outlook.

"There appeared to be a high level of uncertainty about the outlook for retail sales," and shops in some regions were reducing inventory, the survey said.

"Reports suggested developers are becoming more cautious - in some cases shelving or canceling projects," the survey said.

Job growth eased in some regions, the report said. Competitive pressures are keeping a lid on prices, although prices for some inputs are rising.

Where is the Deal Behind The Credit Rescue Fund?

The excerpts below from a WSJ article discusses the credit rescue fund being set up by 3 US banks and initiated by the US Treasury. This group is hoping to have $80B to handle the some mortgage backed securities. Apparently the details about what this fund will purchase have yet to be worked out so as a result there is some question who will eventually sign on.

A planned king-size investment pool to acquire mortgage assets and bolster sputtering credit markets is gaining participants, despite hesitation from some banks and securities firms about joining the effort.

The three lead banks, Citigroup Inc., J.P. Morgan Chase & Co. and Bank of America Corp., are aiming to round up commitments totaling at least $80 billion to make the plan fly, according to people familiar with the matter.

While some people briefed on the plans say that target is fluid, others say that without the kind of critical mass of that large a fund, "it's unlikely to happen," as one put it. The three lead banks expect to ante up less than half the total, the same person said.

The plan, which has been supported by the Treasury Department, is aimed at breaking a logjam in the market for the short-term debt of investment vehicles that hold mortgage-related assets. Those assets have declined sharply in value amid a credit crunch touched off by a downturn in the value of subprime mortgages, or home loans to borrowers with weak credit.

The fund, dubbed the master-liquidity enhancement conduit (MLEC), would issue short-term notes to investors and use the proceeds to buy securities from the specialized funds, known as structured investment vehicles, or SIVs, that are being forced to wind down their businesses. This could help prevent asset sales at fire-sale prices from triggering a market meltdown. There are some 30 SIVs with about $400 billion in assets, according to Moody's Investors Service.

Broad participation in the plan is important to raise sufficient sums of money to produce the jolt of market confidence needed to boost trading in some parts of the credit markets, those involved in the discussions say.

Yesterday, Wachovia Corp. said it will participate in the fund. "While it's not a significant issue for us, we plan to participate at an appropriate level because we want to help improve the stability of the markets," a spokeswoman said.

Among the firms offering support for the plan are Fidelity Investments and Federated Investors Inc. Both hold debt issued by an arm of Gordian Knot Ltd., one of the SIVs that could benefit from the fund.

Some other financial-services firms said they plan to steer clear. Rick Waddell, the new chief executive of Northern Trust Corp. in Chicago, said in an interview yesterday his company has no interest in participating in the superfund as lender or investor, particularly since it has no exposure to the kind of investment vehicles that hold the mortgage securities in question.

Four Wall Street firms, Goldman Sachs Group Inc., Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Bear Stearns Cos., all participated in the exploratory talks about the plan, according to participants, but haven't yet indicated they would join. Morgan Stanley is studying the plan, one person on Wall Street said.

European banks such as HSBC Holdings PLC, Barclays PLC, Deutsche Bank AG, UBS AG and Credit Suisse Group are hanging back, according to people on Wall Street. Such banks have both the big balance sheets and track records in structured finance needed to help generate the broad participation.

Some of those hanging back may be angling for a greater role in the deal, more details, or even higher fees.

Bank analyst David Hilder of Bear Stearns said he believed the backing of the big three U.S. banks would probably get the program off the ground. While Mr. Hilder said he wasn't sure whether the plan would actually mend the ailing markets for mortgage-related securities, he compared its possible impact to "gunboat diplomacy," in which merely "seeing the gunboat on the horizon causes people to behave differently."

Although they have backed the plan -- and even hosted some recent discussions about it -- Treasury officials insist that the fund is strictly voluntary. "We think that people who think it's a good idea should participate," a Treasury official said.

While Treasury officials think the fund will help alleviate stress in the markets and improve liquidity, they said there are other alternatives under way in case the conduit fails to have an impact. "There are lots of other things going on already, such as SIVs being monetized or wound down or refinanced," this official said.

Housing Starts and Permits Are Down, MBA Outlook Is Gloomy Until 2009

The slumping housing market continues with a decline in both housing starts and permits. It looks like the builders are really hitting the brakes (finally). From CCMoney.com:

The pace of housing starts plunged 10 percent in one month to an annual level of 1.19 million, compared to a 1.33 million rate in August.

Housing starts - down nearly 31 percent from year-ago levels are now at their weakest level in 14 years.

Housing permits, which are seen as a sign of builders' confidence in the market, slumped 7 percent to an annual rate of 1.23 million from 1.32 million in August. Economists had looked for permits to slow to a 1.3 million pace.

The news on housing permits was equally bleak: The figures represent the lowest level of permits in more than 12 years, and the latest drop left permits down about 26 percent from a year earlier.

The weak level of building suggests that housing is in an even deeper slowdown than originally expected, as the collapse in the mortgage market, falling home prices and an equally weak market for existing homes has dried up the supply of potential buyers.

Beyond the impact on home sales and prices, the sharp drop in building could also prove to be a major drag on the economy because it depresses employment levels and overall economic activity.

According to Bill Hampel, chief economist for the Credit Union National Association, the housing problems raise to 40 percent the chances that the economy could topple into recession.

A separate Census Bureau report showed there were 180,000 completed new homes for sale at the end of August, just barely below the record 182,000 level seen in May. Further,the National Association of Realtors reports a record 4.6 million existing homes on the market at the end of August.

The second article, also from CNNMoney.com concerns sales declines and housing related layoffs.

For those in the real estate industry and for those looking to buy or sell a home, it could take until 2009 to catch a break. What happens if there is an economic downturn?

That's the forecast from Doug Duncan, chief economist for the Mortgage Bankers Association (MBA) . . . . Duncan expects national median home prices to fall between 2 percent and 4 percent both this year and next. Prices will be held back by an oversupply of homes for sale, an increase in foreclosures and continued uncertainty among mortgage investors.

For this year, Duncan is predicting a 22 percent drop in new home sales and a 12 percent drop in existing home sales, followed by a 10 percent drop in each next year. As home sales fall, Duncan also expects a drop of 15 percent in mortgage loan originations to $1.18 trillion this year, plus another 18 percent drop in 2008 to $1 trillion. . . . .

. . . . The continued weakness will push those in the mortgage industry to further cut their workforce. On top of the 60,000 to 70,000 mortgage-related layoffs that have already occurred, Duncan expects to see another 30,000 to 40,000 by early 2008.

A 40-Year Perspective About Oil

The following link is a slide presentation concerning the last 40 years of history about oil and what lies ahead. If you have never had a chance to read any of the material by Matt Simmons, it is usually worth the time.

Three Gloom & Doom Opinions About the Stock Market

Below are excerpts from three gloom & doom opinions about the stock market. The thing that is interesting about all three is that they are not from some wild-eyed internet blogger, but from three relatively reputable sources: Bill Moyer’s Journal on PBS, the UK Telegraph, and a man that called the 1987 crash.

Once again, I believe firmly that it is good to have a number of opinions from different sources. No one knows what the future holds. The real issue is you need to determine what are the likely scenarios and what level of risk you are willing to live with.

The first one is from the Bill Moyer’s show. The site is worth a visit because it has a clip from the PBS show.

Two prominent economic experts have warned that "insiders with conflicts of interest" allied to the Fed's policy of tanking the dollar to bail out Wall Street could lead to a repeat of the economic crash of 1929, during a segment on Bill Moyers' PBS show.

"I think there are three big parallels between what happened in the 20's and what has been happening in Wall Street lately," Robert Kuttner told Moyers.

Kuttner is a veteran economic journalist and a former legislative assistant in congress.

"One is insiders with conflicts of interest that are not fully disclosed to the public generally, secondly - there's much too much borrowed money....particularly in the financially engineered parts of the economy....and third is the lack of transparency - regulators and the public don't get any kind of disclosure," added the former BusinessWeek writer.

Kuttner called for more transparency and slammed the Fed for recycling a vicious circle of cheapening the dollar to bail out Wall Street, inviting another round of speculative excess.

"The risk is that every time we repeat this cycle, we get bigger and riskier bubbles. And with the dollar being in the tank-- it's not a costless kind of bailout," said Kuttner. "One would have thought that if the dollar were down to 140 Euros there'd be a run on the dollar. We're gonna see inflationary pressures as a result of the cheap dollar. So it's not as if the Fed can simply print more money to bail out these excesses, and there be no cost to everybody else."

William Donaldson, the former chairman of the Securities and Exchange Commission, also warned that the dollar was "disappearing" through the floor as a result of the Fed's policy of bailing out "devious" investors.

So I think that the central banks have a greater technique and ability to meet this problem," said Donaldson. "But insofar as they do-- we run into a moral hazard, i.e. we bail out the people who made bad or devious, or whatever you wanna call 'em, investment decisions. So you sort of are saying, "Go ahead and do whatever you want, and you can count on the good old Fed to bail you out."

The second article is about Paul Jones, who called Black Monday (Oct. 19) 1987. Also included in the article are comments of Robert Prechter, the follower of the Elliott Wave. From the NY Times:

Paul Tudor Jones II . . . .“There will be some type of a decline, without a question, in the next 10, 20 months,” he says in his rich Memphis drawl. “And it will be earth-shaking; it will be saber-rattling.” . . . . .

. . . . . Now, 20 years after the 508-point decline, several strategists are anticipating that the earth will shake again. Valuations are stretched beyond historical comparisons. The market, ever more volatile, is reaching new highs, ignoring a buildup of bad news. Most crucially, the strategists say, the sentiment that the market’s rise is infinite seems to have taken permanent hold.

“The overvaluation of stocks is more extreme than the 1929 high,” said Robert R. Prechter Jr., an independent market forecaster in Gainesville, Ga., and a well-known follower of Elliott Wave theory, which examines the extent to which investor psychology creates stock market patterns. “Which tells me the next bear market will be the biggest in many years, probably since 1929-32.”
Now, Mr. Prechter is suggesting that the country is facing not just a market crash, but also a depression. On every measure, he says, the market is more overvalued than it was in 1987 before the reversal. The price-to-book ratio of the S.&. P 500-stock index today is 4.04, compared with 1.73 in 1987. And measures of the bullishness of Wall Street traders confirm Mr. Prechter’s assessment of the overvaluation.

On Wall Street, the roles are reversed. Mr. Prechter foresees a return to the Depression; Mr. Jones, who himself said a depression would follow the 1987 crash, may well be fully invested.

The third article is from the UK Telegraph. Also look at the graphs below, they are a little to similar. (Also I realize that this is not an exhaustive search for graphs with similar relationships):

Exactly 20 years after "Black Monday" – which saw Wall Street plunge 22.6pc – economists have warned of eerie parallels with the tensions visible on global markets today.

Simon Derrick, chief currency strategist at the Bank of New York Mellon, says the collapse of the US dollar in the mid-1980s lay behind the ructions that led to Black Monday – modern times' most dramatic one-day crash. The dollar had been sliding relentlessly for two years and was at risk of breaking down in a disorderly rout, much like today.

"The dollar was under severe pressure in October 1987. Interest rates were on the rise globally, the US trade deficit remained high and energy prices had been increasing on the back of tension in the Gulf," he said. These conditions are more or less in place once again. . . .

. . . . Jim Baker, the former US Treasury Secretary, said Black Monday's trigger was an interest rate rise by Germany's Bundesbank, forcing the whole European system to raise in lockstep.
The move sparked fears that the US Federal Reserve would have to match with tightening of its own, or risk a further dollar slide and the start of an inflationary spiral. The Fed found itself hemmed in by world forces.

Economists' concern this time is that Asian and Middle East central banks and investment funds are losing their taste for US investments. This could knock away a key prop for the dollar. There is already evidence that Korea, Singapore, Taiwan, Vietnam and Qatar are drawing back. Europe is less likely to prove a trigger today. Even so, European Central Bank governors recently warned that inflation risks are rising, hinting at another rate rise.

John Lonski, Moody's chief economist, said the G7 club of major powers will take pre-emptive action. "I don't think that other central banks would allow the US dollar to collapse. It's not in the interest of the world economy to allow the US dollar to enter a downward spiral," he said.

One missing ingredient this time is that 10-year US Treasury bonds – the world's benchmark price of credit – remain stable. Yields have risen 30 basis points to 4.69pc since the Fed cut the Discount Rate in August. In 1987 they jumped 300 basis points from the start of the year to a pre-crash peak of 10.23pc on October 16, as investors feared a return of 1970s-style inflation. Nor are stocks as richly valued today. The price-to-earnings ratio of Wall Street stocks was 22 in 1987. It is nearer 17 now.

Double click on the image to enlarge.

The Bad News For The Housing Market Continues

Home builders index for October sank to lowest level ever in the 23 years the survey has been completed. Text in bold is my emphasis. From CNNMoney.com:

The National Association of Home Builders/Wells Fargo Housing Market Index showed the overall confidence measure sank to 18, the worst reading on record for the 23-year old monthly survey.

The trade group's statement said the problems included decreased availability of subprime mortgages, a glut of new homes available for sale and reports about declining home values.
The builders' expectations for the market six months from now came in with a reading of 26, matching the lowest reading on record that was set in September. And their view of current buyers' traffic fell to a record low reading of 15.

The overall confidence reading reflects the eighth straight month in which that measure has declined. It has fallen sharply, and is down from a very strong reading of 74 only two years ago. A reading of 50 in any of the three measures indicates the number of positive responses from builders is equal to the number of negative responses.

The IMF Believes The US Dollar Still Has Some Downside Left

The excerpts below are from a WSJ article concerning the IMF’s view of the US dollar. The question that I have is that the US Treasury says it is interested in a strong dollar, but little is done to maintain its value. The text in bold is my emphasis.

Over the "medium term," which is three to five years in IMF parlance, "we still see room for further depreciation," Mr. de Rato said.

The euro, he said, is "very near" its equilibrium value. At a breakfast with reporters yesterday, Mr. de Rato repeated his remarks that the dollar's drop had been "quite substantial." However, he then added his projection that the dollar still had room to fall. IMF officials say his remarks were meant to more accurately convey the fund's view of the dollar and didn't reflect any pressure from the U.S. Treasury or European finance ministries. "There's still some depreciation to come in the medium term," said the fund's chief economist, Simon Johnson.

Mr. de Rato's clarification underscores the difficulty that even experienced financial officials have in dealing with questions of currency. U.S. Treasury officials consistently say they favor a strong dollar, but they do nothing to defend the currency as it falls in value. They declined to comment on the issue.

In effect, the U.S. government depends on a steady decline of the dollar to narrow the nation's current-account deficit. If that deficit remains too wide, many economists worry, it could ultimately lead to a crash in the dollar.

The U.S. and Europe also have been pushing China to let its currency rise in value against both the dollar and euro as a way to minimize "global imbalances" and give a lift to U.S. and European exporters. Mr. de Rato repeated the IMF's view that the yuan "should have more flexible movement," which he said was in China's interest because it would "allow for strong growth and strong domestic consumption."

Bernanke Comments on the Economy

Ben Bernanke gave a speech yesterday at the Economic Club of New York giving his views on the current economy. Based on his comments I would not bet on a rate cut on October 31. Text in bold is my emphasis. From CNNMoney.com:

In a speech to the New York Economic Club Monday night, Federal Reserve Chairman Ben Bernanke said the central bank's rate cut in September has shown signs of success, but cautioned that lenders and investors must bear responsibility for financial decisions that caused the subprime mortgage meltdown.

"Although the Federal Reserve can seek to provide a more stable economic background that will benefit both investors and non-investors, the truth is that it can hardly insulate investors from risk, even if it wished to do so," Bernanke said, adding that "over the past few months...those who made bad investment decisions lost money."

The Fed slashed the federal funds rate, a key short-term interest rate that impacts rates on consumer loans, by a half of a percentage point on September 18. Bernanke said the rate cut, combined with an earlier cut to the symbolic discount rate in August, helped to "reduce some of the pressure in financial markets" and that "the improved functioning of financial markets is a positive development."

Bernanke also said that the weakness in the housing market "is likely to be a significant drag on growth in the current quarter and through early next year."

But he hinted that it may not get that much worse and that investors and lenders may have learned from their mistakes. He did not specifically mention a plan unveiled Monday by a group of big banks to create a fund to buy mortgage-backed securities in his prepared remarks, however.

"Rather than becoming more crisis-prone, the financial system is likely to emerge from this episode healthier and more stable than before," he said.

But during a question and answer session following his speech, Bernanke said it will take a while for investors to appropriately value subprime and jumbo mortgages.

Investors looking for a sign that the Fed may cut rates again at the conclusion of a two-day meeting on October 31 may be disappointed though. He indicated that the Fed "was prepared to reverse the policy easing if inflation pressures proved stronger than expected."

He added during the question and answer period that the Fed may need to make sacrifices in order to ensure the long-term health of the economy. "Using monetary policy is very difficult," he said.

Bernanke also brushed off concerns about a weak dollar prompting inflation. When David Malpass, chief economist at Bear Stearns, asked Bernanke if he thought the value of the dollar impacts inflation, Bernanke said he did not think a fixed exchange rate would be good for the economy.

In Case You Thought The Problems In Credit Markets Was Over

Just in case you thought the problems in the credit markets was over, it looks like some big US banks are putting together a fund to help bail out structured investment vehicles. I found it interesting that this article came out over the weekend. No need to upset the markets on a trading day. By the way, the credit market issues have not been resolved by a long shot. From Bloomberg:

Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co., the three biggest U.S. banks, agreed to set up a fund of about $80 billion to help revive the asset-backed commercial paper market, according to people familiar with the discussions. . . . . The fund will buy assets from structured investment vehicles (SIVs), units set up to finance purchases of securities such as bank bonds and mortgage debt.

Other banks may join the fund, which would help SIVs avoid selling their $320 billion in holdings at fire-sale prices, further roiling the credit markets, the people said. The Treasury Department in Washington initiated the talks between the banks after a shutdown of the commercial paper market left SIVs and other sellers unable to borrow, forcing sales of about $75 billion of assets. .

. . . . The Treasury jump-started talks between banks with a meeting of Wall Street executives in Washington on Sept. 16, said a person with knowledge of the deliberations. Robert Steel, the Treasury's top domestic finance official, brought the lenders together and prodded the competitors to keep working through the following weeks. Treasury Secretary Henry Paulson, a former chief executive officer of Goldman Sachs Group Inc., also made calls. . . . .

. . . . . The sudden increase in borrowing costs for companies and consumers in August threatens to worsen a housing recession that has slowed the pace of economic growth.

The fund will be known as the Master Liquidity Enhancement Conduit, or MLEC, the people said. The fund will buy securities rated AAA or AA at Standard & Poor's and Aaa or Aa at Moody's Investors Service at market prices, the people said. It won't buy subprime mortgage assets, they said.

``This is mostly symbolic,'' said Christian Stracke, a London-based strategist at CreditSights Inc., a New York bond research firm. ``The banks were going to need to inject more liquidity into the SIVs anyway, so the public co-operation just makes the bail-outs of SIVs seem more orderly.'' . . . .

. . . . . Banks worldwide manage a total 36 SIVs, according to a Moody's report in July. Bank of America, based in Charlotte, North Carolina, and New York-based JPMorgan manage conduits that sell asset-backed commercial paper typically to finance deals for clients. JPMorgan sold its SIV business to Standard Chartered Plc in London last year.

Encouraging the talks that led to the creation of the fund is the latest effort by officials to help restore liquidity to credit markets, a campaign started by the Federal Reserve in August, when it cut the interest rate on direct loans from the central bank. Fed officials have said this month that while there are signs of improvement, some markets remain under stress.

``Some markets have been experiencing illiquidity,'' San Francisco Fed President Janet Yellen said in an Oct. 9 speech in Los Angeles, referring to mortgage-backed securities and asset- backed commercial paper. ``This illiquidity has become an enormous problem for companies that specialize in originating mortgages and then bundling them to sell as securities.''

As losses in securities linked to subprime mortgages started to spread in July, investors retreated from high-risk assets. The amount of asset-backed commercial paper outstanding tumbled to $899 billion in the week ended Oct. 10, from a high of $1.14 trillion at the end of June, according to Fed figures.

Mortgage defaults by Americans with poor credit histories prompted the collapse in June of two hedge funds managed by Bear Stearns Cos. and triggered a worldwide rout in the debt markets. The European Central Bank began adding liquidity on Aug. 9 after BNP Paribas SA, France's biggest bank, was forced to halt withdrawals from three of its investment funds. The Fed followed, along with counterparts from Sydney to Oslo.

As yields on asset-backed commercial paper climbed amid the exodus from the market, some companies found their access to borrowing cut off. Countrywide Financial Corp., the biggest U.S. mortgage lender, had to tap an entire $11.5 billion bank line on Aug. 16 after being unable to fund itself with commercial paper.

SIVs run by hedge funds including Cheyne Capital Management Ltd. in London and TPG-Axon Capital Management LP in New York were forced to sell assets at a loss after being shut out of the short-term debt market.

On average, SIVs lost 1.3 percent from the face value of assets sold since August, with shortfalls as high as 13.7 percent on some holdings, Fitch Ratings said in an Oct. 12 report on the funds it grades.

While concern about rising subprime mortgage defaults triggered the losses on SIVs, the funds only have about 2 percent of holdings invested in the debt. SIVs have about 41 percent in financial-sector debt, 22 percent in prime residential mortgage securities and 12 percent in collateralized debt obligations. Commercial mortgage-backed securities and non- mortgage asset-backed bonds each account for a further 8 percent, according to a Sept. 11 report by UBS AG in Zurich.

Alex Roever, a debt strategist at JPMorgan in New York who wasn't involved in the negotiations, estimates that SIVs have at least $320 billion in assets.

``Eighty billion is great, but it's not that big a number,'' said Roever. ``It still leaves you with $240 billion. That's a lot of dough. There may be enough money to pay the senior debt holders, but it's not enough to pay off everyone else.''

The Upcoming G-7 Meeting and Related Fireworks

The upcoming G-7 meeting could be fairly interesting this time. When the dollar depreciates against the euro biting into European exports someone will have something to say. Also some European banks have taken some hefty losses in response to the US housing slump. This is also going to get someone’s attention. From Bloomberg:

A former Master of the Universe like Henry Paulson doesn't often find himself on the defensive. At international meetings this week in Washington, he will be.

Under pressure from European governments to abandon his hands-off approach to financial regulation and the depreciating dollar, the U.S. Treasury secretary and former Goldman Sachs Group Inc. chief executive officer may be forced to accede to the first while resisting the second.

European nations are leading the charge against him (Paulson). With the euro hitting a record high versus the U.S. currency, European exporters are being priced out of foreign markets.

``Sales of German exports are falling off drastically in the U.S.,'' says Anton Boerner, president of the Berlin-based BGA association of wholesalers and exporters. ``We've stepped beyond the pain threshold.''

France has been particularly vociferous in advocating action to stem the euro's rise, with Finance Minister Christine Lagarde, 51, even pushing the European Central Bank to sell the currency. She has also called on Paulson to say ``loud and clear'' that he still backs a strong dollar.

While Paulson has said repeatedly that a strong dollar is in America's interest, he says the value of currencies should be set by the market. Under President George W. Bush, the Treasury has never intervened in the currency market, either to buy or sell dollars.

``The most important thing for the U.S. is to maintain the stance on currencies that they've had,'' says John Taylor, Bush's former Treasury undersecretary for international affairs and now a professor at Stanford University in California. He says it's ``unlikely'' Paulson's rhetoric will change.

Paulson should be able to fend off pressure in part because the Europeans themselves aren't united on the issue. In spite of complaints from exporters, Germany has made clear it doesn't want to weaken the euro, with Finance Minister Peer Steinbrueck saying Oct. 9 that the currency's recent rise is ``nothing sensational.'' . . . .

. . . . What's more, the dollar's fall -- it's dropped more than 8 percent this year against a broad basket of currencies -- has helped boost U.S. exports and the economy at a time when the housing slump has slowed the expansion. Trade added 1.3 percentage points to growth in the second quarter, its biggest contribution since 1996. . . . .

. . . . ``Paulson seems to be moving a bit away from the view that there's nothing absolutely wrong with the markets, that the less regulation there is the better,'' says Edwin Truman, a former Federal Reserve and Treasury official who's now at the Peterson Institute for International Economics in Washington.

European policy makers have pinned much of the blame for the market turbulence on what they see as lax U.S. supervision of subprime-mortgage lenders.

If U.S. regulators ``had actually looked closely'' at whom financial institutions were lending to, ``some of these problems might have been avoided,'' U.K. Chancellor of the Exchequer Alistair Darling told BBC Radio Sept. 14.

In response to similar criticism from Congress, Fed Chairman Ben S. Bernanke agreed with state regulators to collaborate on supervision and enforcement of nonbank subprime lenders.

Europe is also pushing for increased supervision of U.S. ratings agencies, arguing that they have been too lenient in judging the creditworthiness of subprime loans and the securities they are packaged into. Among possible changes: separating the agencies' consulting businesses from their ratings services, so they wouldn't be advising the same companies whose securities they're grading.

This Weekend's Contemplation - Why the Dollar Will Weaken

Something to consider as you manage your portfolio, your thoughts on foreign affairs, the position of the US amongst the world economies, etc. Also realize that as the US dollar declines it builds it new bubble in a different asset type.

The only portion of the article extracted for this blog deals with a weakening dollar. The article also contains investment advice. Text in bold is my emphasis. From MSN Money:

The dollar hasn't been this low in a decade, but it's headed lower. By the end of 2007, we can expect the dollar to buy 11.6% less versus the euro than it did at the beginning of the year.

As the dollar continues its slide, count on Wall Street to gear up its fear machine.

Any further retreat in the dollar will put the U.S. currency on the edge of unexplored territory. The fall of the U.S. dollar into unknown territory, the argument is likely to go, would break the will of those overseas central banks, from Russia to Saudi Arabia to China, that have been buying dollars to give their countries' exports a competitive edge.

Well, I'm sorry, but I just don't buy that scenario. Wall Street could, of course, scare itself into a dollar rout because many of the folks who work there are so traumatized by the crises in the markets for mortgages and for buyout loans that they're likely to jump at shadows, even when the shadows are of their own making.

I think it's much more likely that we'll continue to see a steady decline in the dollar, punctuated by rallies as traders take profits. The Federal Reserve, which rode to the rescue in the August crisis, can't do much this go-round. Cutting interest rates to save economic growth hurts the dollar. Raising interest rates to help the dollar would hurt the economy. . . . .

. . . . to lay out the logic for a gradual dollar decline -- no reason to panic . . . .

Here's why the dollar is likely to keep dropping for a while:

• The U.S. runs a huge, though falling, trade deficit with the rest of the world, about $700 billion annually at current monthly rates. That leaves our trading partners holding an ever-expanding number of dollars.
• In recent years, only relatively higher U.S. interest rates -- and some premium from the economic stability that comes with being the world's biggest economy -- have kept demand for dollars roughly in step.
• As the economies of Europe and, for much of the year, Japan have grown faster than the United States in 2007, central banks in those countries have raised interest rates, cutting into the premium investors could earn by holding dollars.
• As interest-rate differentials have narrowed, as the U.S. economy has slowed and as a weaker dollar has cut the returns to overseas investors, demand for the dollar has weakened. And so has the price of the dollar.

A weak dollar helps the U.S. increase exports, cut imports and reduce the trade deficit. But how do other countries deal with it? . . . . Let their currency appreciate or try to manage the exchange rate.

That decline would have been much more precipitous if some of our trading partners hadn't actively propped up the value of the U.S. dollar. No altruism there, just straightforward self-interest. The Chinese government, for example, has continued to buy dollars in order to keep the value of its own currency from rising.

A more expensive yuan would make Chinese goods more expensive to U.S. buyers in particular and to global customers in general. In China, that would cut the economy's growth rate, slow job creation and almost certainly mean the loss of jobs in the least efficient of the state-owned companies that still employ millions of workers. In effect, the Chinese and other governments have opted to spend some of the dollars that their economies earned in trade on subsidizing jobs for their work forces.

Despite saber rattling by the world's central banks, there's little evidence that of any of them are abandoning U.S. dollars even as the currency tests new lows. The International Monetary Fund's numbers show a slight shift from dollars into euros, with the dollar share falling to 64.2% of all global reserves in the first quarter of 2007 from 64.6% in the last quarter of 2006.

But much of that shift is a result of an appreciation in the euro holdings of these central banks and the depreciation of the dollar. Certainly, the Federal Reserve's more recent balance sheet of Treasury and agency bonds doesn't show a big shift out of dollars. Foreign central banks held $1.995 trillion of this paper at the end of September, up from $1.673 trillion in September 2006.

To the degree that any asset shifting has taken place in 2007 by central banks, it was out of Treasurys and into higher yielding paper such as mortgage-backed debt, or buyout loans or derivatives based on those assets. The move came just in time for these banks to take a beating in this summer's meltdown in those markets. I suspect that for the moment, these banks aren't overly eager to take on more risk.

Still, I think after a relatively short breathing space, the world's central banks will start looking for a solution again because the problem is too big to ignore. Subsidizing domestic jobs is all well and good, but a falling dollar makes it increasingly expensive.

An 11.6% decline in the dollar against the euro means that every dollar in China's $1.2 trillion foreign-exchange reserve -- and dollars make up something like 70% of that reserve -- are worth that much less when the country goes to buy anything from the European Union, China's second-largest trading partner. That's not an insignificant issue when you're importing about $90 billion in goods from Europe annually.

Same goes for Russia and Saudi Arabia, where the biggest exports are denominated in dollars but many imports have to be paid for in euros.

The overseas central banks -- or more accurately, the governments behind them that decide on how many jobs to buy by spending reserves to keep their currency from appreciating versus the dollar -- have a pretty high threshold of financial pain. But it's not infinite.

The conventional argument has long been that these banks would support the dollar no matter what because they didn't have a choice. What currency could replace the dollar?

But that argument looks out of date. The countries with huge reserves may still need to keep dollars for trade, but, increasingly, they're looking elsewhere for their investments. The new vehicle is the sovereign investment fund, with capital provided from national reserves for investment in assets around the globe. The models here are the investment funds of Norway and Singapore that have bought stakes in foreign telecommunications companies, airlines and financial companies.

And those investments look pretty attractive now that developing countries' stock markets are beating the returns from investing in the United States. Why buy more of the risky assets that just blew up when you can earn a better return in India or Brazil or the Philippines?

Where does that leave the United States? In a tough competitive position on the currency front.

The recent blowup in the U.S. mortgage- and buyout-loan markets couldn't have come at a worse time competitively. Big losses in these dollar-denominated investments eroded some of the edge that dollar investments had in the minds of investors over investments in developing markets. The bigger the losses in that debacle, the longer it takes to work out and the less transparent that market remains, the more overseas central banks will look to developing markets for the gains they can't get in U.S. dollar assets. (In my mind the most serious fall-out of the housing crash. Because of the mortgage backed security debacle the US has lost credibility in the international markets, where it is all about credibility.)

That doesn't add up to a quick stampede out of dollars. Instead, look for the decline in the dollar to continue at a gradual pace as developing markets win more of the world's cash.

As Home Equity Debt Growth Slows – Credit Cards Pick Up The Slack

As anticipated by many as the growth in home equity slowed in 2007, the consumer moved to credit cards to pick up the slack. At this point there do not appear to be delinquency problems. Text in bold is my emphasis. From Reuters:

The automated teller for home loans is empty and Americans are relying increasingly on credit cards to pay their living costs, indicating tough hurdles ahead for U.S. consumer spending and markets.

Federal Reserve data released on Friday showed U.S. consumer borrowing rising by $12.18 billion in August, more than 20 percent more than economists had forecast.

Most striking was an 8.1 percent increase in borrowing on revolving credit lines, mostly credit cards, to a record $909 billion.

Credit card borrowings rose at the sharpest rate since early 2002. . . . .

. . . . Retail sales rose just 0.3 percent in August, and when motor vehicles and parts were stripped out, sales fell 0.4 percent, the sharpest drop since September 2006.

Considering that people always have to eat and many Americans have only limited discretion over how much gasoline they use, a period when credit card debt is expanding rapidly while retail sales are contracting points to debt financing of necessities, rather than luxuries. . . .

Ryan Sweet of Moody's Economy.com notes that mortgage equity withdrawal has been down sharply on a year-on-year basis, a factor that if extended would force consumers further into the arms of their credit card lenders.

Interestingly, the market for credit card based asset-backed securities has recently become quite hot.

Credit card ABS issues in the United States is the only asset-backed segment to experience growth in 2007, up 30 percent on the year to September to $69.2 billion.

Spreads have tightened as well, after having widened considerably over the summer.

Delinquencies are still low, though the most recent data covers only the second quarter. Late payments on bank cards fell in the second quarter to 4.39 percent from 4.41 percent, according to the American Bankers Association.

Sales at Retail Stores Are Weak In September

Sales at the largest retailers was relatively weak in September. As with previous months the high–end retailers such as Saks or Neiman Marcus showed positive sales growth where the “everyday” retailers (i.e. Kohl’s, J.C. Penney, etc.), where most people shop, showed a decline in sales.

Below is a table extracted from data given in the WSJ showing the September sales by retailer. Also given is the year-over-year (YOY) change in sales for comparable stores. Admittedly, this is not all the retailers and it only represents the largest retailers, but a few interesting things are worth noting.

1. Retail sales are dominated by just a few stores.

2. Once again the data clearly indicates that most “everyday” retailers have shown a decline in sales YOY.

3. The sales weighted average YOY growth is 0.94% in September. Correcting for
inflation, September sales did not keep up with inflation. Therefore, “real” retail sales growth has declined in the last year.

Retail Sales Are Up In September

Retail sales are stronger then anticipated in September. It should be noted, however, that most of the increase was do to car and auto related sales and not sales at stores. Although I am sure this will be heralded as “no recession” in the financial press, a lack of consumer spending at the store is of some concern. Parts in bold are my emphasis. From the WSJ:

. . . . Retail sales increased by 0.6%, the Commerce Department said Friday. Sales went up an unrevised 0.3% in August. The 0.6% increase was higher than forecast; the median estimate of 22 economists surveyed by Dow Jones Newswires was a 0.3% advance. . . .

. . . . The first estimate of third-quarter GDP, which ended Sept. 30, is due for release Oct. 31. Analysts expect the data will show spending, buoyed by falling gasoline prices, picked up from its tepid second-quarter performance. Fourth-quarter spending, however, is another story, expected by analysts to soften due to dropping home prices, tighter credit, and a softer labor market.

If not for car sales, overall retail sales in September wouldn't have gone up so high. The Commerce report showed automobile and parts sales increased by 1.2% in September. August sales surged 3.3%. Sales of all other retailers excluding auto and parts dealers increased in September by 0.4%. Economists expected a 0.4% increase. Ex-auto sales in August had fallen an unrevised 0.4%.

September gasoline-station sales rose by 2%. Gas sales fell 2.6% in August. Stripping away sales at gas stations, demand at all other retailers increased 0.4% in September. Excluding gas and auto sectors, demand at other retailers last month increased by 0.2%.

Sales in September climbed by 0.9% at electronic stores; 1.0% at health and personal care stores, 1.1% at mail order and Internet retailers; and 0.8% at food and beverage stores.

Home-improvement store sales were listless. Sales at building material and garden supplies dealers inched 0.1% higher. Furniture store sales dropped, down 0.6%. Sales fell 0.7% at sporting goods, hobby and book stores; 0.1% at general merchandise stores; and 0.4% at clothing stores. Demand was flat at eating and drinking places.

The Rich Keep Getting Richer

This short article from Yahoo ties in well with yesterday’s post concerning the polarizing job market. The middle of the US population is getting squeezed in terms of income and job availability. Someone will have to explain to me why this is a good thing. Also the WSJ has a longer article on the same issue that goes more into depth about the income inequality and its political ramifications.

There is an old expression in business that applies here. "If everyone doesn't make money, then no one makes money."

The richest one percent of Americans earned a postwar record of 21.2 percent of all income in 2005, up from 19 percent a year earlier, reflecting a widening income disparity among different classes in the nation, the Wall Street Journal reported, citing new Internal Revenue Service data.

The data showed that the fortunes of the bottom 50 percent of Americans are worsening, with that group earning 12.8 percent of all income in 2005, down from 13.4 percent the year before, the paper said.

It said that while the IRS data goes back only to 1986, academic research suggests that the last time wealthy Americans had such a high percentage of the national income pie was in the 1920s.

The article cited an interview with President Bush, who attributed income inequality to "skills gaps" among various classes. It said the IRS didn't identify the source of rising income for the affluent, but said a boom on Wall Street has likely played a part.

What Is Up With The Market?

What is up with the market? It is acting as if it has no confidence.

The price of oil is up $1.78.

The price of gold is up $10.70.

The price of silver is up.

The S&P 500 hits a new high today.

The DJIA hits an intraday high.

Volume in the stock market remains anemic.

Then starting at 2pm (EST), shortly after the markets hits their highs, the markets starts a decline (see charts below from Yahoo). This is after all the bad news about retailers has already been announced.

Oil in the $90 - $95 Range May Not Be That Far Fetched

Without a recession or something else to slow down the economy and thereby decrease the demand for oil in the US and the rest of the world, oil prices in the $90 dollar range may be sooner than you think. From CNNMoney.com:

By the way, I have freinds in the oil and gas business and I am hearing the same sorts of things from them as the interviewee states. Also this article ties in with a post last week.

Crude oil prices hit a series of record highs in the past month, topping $83 a barrel - and that was after OPEC announced it would increase production by 500,000 barrels a day. The sharp spike went against post-Labor Day tradition, when the end of a gas-guzzling summer usually brings lower prices, and refineries head into their fall maintenance schedule.

After Goldman Sachs raised its year-end price forecast by $13, to $85 a barrel, Jeffrey Currie, global head of commodities research in London, spoke to Fortune's Eugenia Levenson about

What's behind the recent surge in crude oil prices?

The OPEC supply increase was too little, too late. The market is in a significant deficit, the first deficit we've seen since 2003. Inventory started to drop in October of last year for two reasons. Non-OPEC supply has been extraordinarily disappointing, because those producers are hitting technical difficulties with new equipment and their existing fields are getting less productive. OPEC has the supply but hasn't brought it online. The second factor is that we're in the part of the energy cycle where extraction costs are rising and have been since 2001.

So how high will prices climb?

Our high-risk scenario is in the $90 to $95 a barrel range. I think there's high probability we'll get there, rapidly approaching 50%. The later OPEC is in responding to the higher prices, the sharper the deficit and the more critical the drawdown on inventory this winter - and the more volatile the price spikes. They'll have to respond by first quarter of next year, barring a global collapse in demand.

Why hasn't OPEC increased supply?

First and foremost, domestic demand is strong in the entire Gulf region. Exports from the Middle East are lower today than they were in 2000, but production is up two million barrels a day. There are serious bottlenecks preventing non-OPEC from growing supply even at $70 per barrel, so if I'm OPEC, I know I don't have significant competition for market share. The last reason, which is very important, is that if OPEC did ramp up production, they'd go to capacity, which would reduce their political negotiating position.

What does an $80 barrel mean for gas prices?

This is a crude story. Retail prices are lower today on $80 a barrel than they were in May. At Memorial Day, the average price at the pump was $3.25 a gallon, and at Labor Day it was $2.86 a gallon. Although oil prices are an important component of gasoline prices, the refinery margins are also very important. (my comment)

What's keeping retail prices low?

Refining margins [profits earned by the refiner] dropped from 74 cents a gallon in May to 19 cents. The main reason for the high margins in the summer was an unprecedented number of refinery outages. In part, that's because of continuing problems from hurricanes Katrina and Rita. It's also true that significant increases in environmental regulations on fuel create a higher probability of these types of mishaps. There were also distribution problems during that time period, which led to higher marketing margins [profits earned at the retail level]. But now the gas stations' take has dropped from 47 cents a gallon to 32 cents.

Refining margins have come down, but will they start rising again?

We're modestly bullish on refining margins. They will probably get bigger, though not as big as in May. That's why I don't think that even if crude goes to $90 a barrel, retail prices will be as high as they were. Stocks in the refining sector were pulled down by concerns over the credit crisis as well as declining refining margins. Investors are not pricing in the potential rebound in margins.

Higher gas prices this summer didn't seem to dent demand. Why?

It's the price change that matters. In September 2005, retail gasoline prices reached an all-time high of $3.11 a gallon. That was a 70% year-over-year increase, and it killed off U.S. gasoline demand and significantly impacted economic growth. This May prices reached a new all-time high of $3.25, a 12% increase year-over-year, and it didn't even make the headlines. The consumer had already adjusted to the $3 level.

There Is Some Upside to a Weaker Economy and Dollar

The dark clouds of a weaker economy and dollar does have some silver lining. From the WSJ:

Retailers will be reporting September sales today, and it doesn't appear they'll be pretty. The International Council of Shopping Centers estimates sales at stores open for a year or more will be 2% above last year's level -- barely enough to keep up with inflation. Meantime, the Commerce Department is set to report the August trade balance. Economists polled by Dow Jones Newswires estimate the trade gap narrowed a bit to $59 billion from $59.2 billion in July and a record $67.6 billion in August 2006.

The two -- the weakness at the stores and the drop in the trade deficit -- are related. A large chunk of what gets sold to consumers these days gets produced overseas. When spending slows, imports to the U.S. are affected.

As a result, past U.S. consumer slowdowns were seen as a major threat to the world economy. But now growth seems to be bubbling along outside the U.S. That, in combination with the weak dollar, is increasing demand for U.S. goods and services.

A sign of how rapidly the trade situation is changing: In August, 41% of the containers shipped from the Port of Los Angeles were loaded, up from a year-earlier 32%.

With exports rising and imports slowing, the U.S. trade deficit has been getting whittled away. That's one important bit of good news for an economy facing plenty of challenges right now. Rising exports underpin domestic growth, slowing imports mean the pain of a consumer slowdown is dispersed far and wide and a narrower deficit means Americans are in effect saving more of what they earn.

The Polarizing Job Market

The job market in the US is polarizing. The demand is at the low end of the pay scale in various service sectors, for example, gardeners or day-care workers. On the other end of the pay scale the demand is also increasing (lawyers, accountants, etc.). In the middle, the jobs in factories or offices that require routine sorts of work such as a bookkeeper or assembly line worker are disappearing and the wages at that level are stagnating.

This article in the WSJ is worth a read. If you are young it gives you an indication about what you should do about school. If you are older it tells you where your job may be going or in what direction your children should go.

Want a job for sure? How many languages can you read and write? If your answer is more than one you stand a chance. If one of those languages is Asian your chances went up more.

The salaries of Wall Street's financial engineers are surging while wages in industrial companies stagnate. Manufacturers complain about "skill shortages" while cutting payrolls. The number of health-care jobs soars 45% over 15 years, outstripping the 25% increase in other jobs. Computers seem to have infiltrated every job, yet demand for unskilled, low-wage immigrants doesn't abate.

There is still strong demand for high-end workers -- the stars of finance, software, law, sports and entertainment -- as well as for the highest-skilled factory workers. The only news is the intensity of that demand, which is pushing up pay for those at the top.

But -- and here's the switch -- demand is increasing for some workers at the low end of the pay scale: the ones who wipe brows in hospitals, care for kids, clear tables at bistros and stand guard in office-building lobbies. In 1980, about 13% of workers without any college education were working in such personal-service jobs, according to calculations by David Autor, a Massachusetts Institute of Technology economist. In 2005, 20% of them were.

The losers? "The sagging middle," says Princeton University economist Alan Krueger.

As Harvard economists Lawrence Katz and Claudia Goldin put it recently, "U.S. employment has been polarizing into high-wage and low-wage jobs at the expense of traditional middle-class jobs."
Here's the hypothesis evolving among these and other academics. Technology and globalization are boosting demand for the most-educated workers, those prized for abstract or conceptual skills. Top hedge-fund managers aren't being replaced by computers; they're harnessing them, to their great profit.

By contrast, technology and globalization are eroding demand for workers who do routine tasks in factories and offices, many of whom are high-school or even college grads. The voice-mail system does away with switchboard operators; back-office software eliminates bookkeepers; robots replace assembly-line workers. Or the work is shipped overseas to a foreign factory or an office linked to the U.S. by fiber-optic cables.

But technology and globalization are not eroding demand for personal-service workers. Those tasks can't be done by computer or shipped offshore. The services have to be delivered here in the U.S. -- and in person -- either by natives or by immigrants.

Dissecting data on 741 American communities, MIT's Mr. Autor and colleague David Dorn examined places that were particularly heavy with easy-to-automate or easy-to-outsource jobs in 1980. By 2005, they discovered, wage inequality in those communities had widened more than elsewhere. The erosion of jobs and wages in the middle coincided with increasing employment and wages for personal-service workers at the bottom of the income ladder and highly educated workers at the top.

Some economists speculate that the same economic forces are at play in Europe, but are hidden because rules and customs that restrain incomes at the top also restrain demand for personal-service workers at the bottom. That means less inequality than in the U.S., but also fewer jobs overall and more people on the sidelines, the ones who would be service workers if there were jobs to be had.

Subprime Mortgages are More Widespread Geographically and Economically Then Previously Thought

The WSJ completed the first large-0scale public analysis of the sub-prime market. The results in a nutshell shell are sub-prime mortgages are more pervasive across the country then previously thought. They cut across geographic and income boundaries more evenly then previously thought. The real estate slump will be with us for some time to come. This article is worth a read with some good maps and charts.

As America's mortgage markets began unraveling this year, economists seeking explanations pointed to "subprime" mortgages issued to low-income, minority and urban borrowers. But an analysis of more than 130 million home loans made over the past decade reveals that risky mortgages were made in nearly every corner of the nation, from small towns in the middle of nowhere to inner cities to affluent suburbs.

The analysis of loan data by The Wall Street Journal indicates that from 2004 to 2006, when home prices peaked in many parts of the country, more than 2,500 banks, thrifts, credit unions and mortgage companies made a combined $1.5 trillion in high-interest-rate loans. Most subprime loans, which are extended to borrowers with sketchy credit or stretched finances, fall into this basket.

High-rate mortgages accounted for 29% of the total number of home loans originated last year, up from 16% in 2004. About 10.3 million high-rate loans were made in the past three years, out of a total of 43.6 million mortgages. High-rate lending jumped by an even larger percentage in 68 metropolitan areas. . . .

To examine the surge in subprime lending, the Journal analyzed more than 250 million records on mortgage applications and originations filed by lenders under the federal Home Mortgage Disclosure Act. Subprime mortgages were initially aimed at lower-income consumers with spotty credit. But the data contradict the conventional wisdom that subprime borrowers are overwhelmingly low-income residents of inner cities. Although the concentration of high-rate loans is higher in poorer communities, the numbers show that high-rate lending also rose sharply in middle-class and wealthier communities. . . . .

. . . . High-rate loans are those that carry interest rates of three percentage points or more over U.S. Treasurys of comparable durations.

The Journal's findings reveal that the subprime aftermath is hurting a far broader array of Americans than many realize, cutting across differences in income, race and geography. From investors hoping to strike it rich by speculating on condominiums to the working poor chasing the homeownership dream, subprime loans burrowed into the heart of the American financial system -- and now are bringing deepening woe.

The data also show that some of the worst excesses of the subprime binge continued well into 2006, suggesting that the pain could last through next year and beyond, especially if housing prices remain sluggish. . . . . (my emphasis)

. . . . The data suggest that financial suffering is likely to persist in many parts of the U.S. where subprime lending had surged. Many loans at risk of going bad have not yet done so. As much as $600 billion of adjustable-rate subprime loans, for example, are due to adjust to higher rates by the end of 2008, which means that more and more borrowers are likely to fall behind. . . . .

. . . . Seven of the 10 large metro areas now struggling with the highest foreclosure rates -- including Miami, Detroit and Las Vegas -- saw borrowers barrel into high-rate loans much faster than the country as a whole. In a forthcoming study in the Journal of the American Planning Association, Daniel Immergluck, an associate professor at Georgia Institute of Technology in Atlanta, found a similar pattern between foreclosures occurring in early 2006 and cities with high subprime lending in 2003.

. . . . Higher-income home buyers began using such loans for larger purchases. Among borrowers characterized in the data as white with annual income of at least $300,000, the number of high-rate loans jumped 74% last year, the numbers show. The average high-rate loan grew 10% to $158,000 last year, compared with a 1% rise in the average size of all home loans. The 2006 data include records from 8,886 lenders nationwide, which generate an estimated 80% of U.S. home mortgages.

Who will be left holding the bag for mortgages that go sour? Wall Street bought lots of subprime loans and packaged them into securities for sale to investors. The data show that lenders shifted even more of their riskiest loans to investors as the boom began to fizzle.

About 63% of high-rate mortgages originated in 2004 were sold that same year, compared with 68% of all home loans, the data indicate. Last year, about 73% of new high-rate loans were sold, compared with 67% of all home loans. Last year, the average high-rate loan carried an interest rate that was 5.6 percentage points higher than a Treasury security of comparable maturity -- up from 5.3 points in 2005 and 4.8 points in 2004.

Speaking of Recession Related Issues – Strip-Mall Vacancies are Up

In keeping with the continuing debate about the future growth of the US economy, strip mall vacancies are up marginally, indicated that the consumer spending is declining. From the WSJ:

U.S. strip-mall vacancies only inched up in the third quarter, but still hit a 5½-year high, spurring concerns about cutbacks in consumer spending. Rentals of retail space in weak housing markets are getting hit disproportionately hard, as consumers rein in their purchases. . . .

. . . . "There's uncertainty in the market, and there's uncertainty on the part of retailers as to how consumers will respond to the changing conditions," says Sam Chandan, chief economist at Reis Inc., a New York real-estate research firm.

The strip-mall vacancy rate rose to 7.4% in the third quarter, from 7.3% in the second quarter and 7% in the year-earlier period. Along with the first quarter of 2002, when the vacancy rate was also 7.4%, that level was the highest in 11 years, according to a survey of 76 U.S. retail markets by Reis.

In states such as Florida and California, where housing markets are among the weakest in the country, retail fundamentals have markedly softened in some places. . . . Vacancies have also risen and rent growth slowed in weak housing markets such as Miami, Tampa, Phoenix, Orange County, Calif., and San Bernardino/Riverside, Calif.

Retail in most of the rest of the country is still solid. "Between the coasts, we're not seeing as much of an impact, because that's not where a lot of the [housing] prices were inflated," says Greg Maloney, chief executive of retail at Jones Lang LaSalle, a Chicago-based commercial real-estate firm. . . .

. . . . Shopping-mall vacancies have shown no impact from the housing problems yet. Because of malls' long lease terms, economic problems typically take 18 months to 24 months to show up in vacancies and rents. The vacancy rate for shopping malls fell to 5.5% in the third quarter from 5.6% in the second, and rents rose 0.7%, according to Reis. Strip malls see the effects sooner, but ultimately could be more stable than shopping malls, which depend more on discretionary spending.

Summary of the Fed Meeting That Decided to Cut the Fed Funds Rate

Nice short summary of the why the Fed decided to cut the Fed Funds rate. From the WSJ:

Federal Reserve officials worried that credit-market turmoil could reinforce slower growth at a time of "particularly high uncertainty," leading to their half-point interest-rate cut last month, minutes from the meeting show.

Without a cut, there was concern that "tightening credit conditions and an intensifying housing correction would lead to significant broader weakness in output and employment," the rate-setting Federal Open Market Committee said. The minutes, released yesterday, also showed members worried that market turmoil "might persist for some time or possibly worsen." They offered no clues about the direction or timing of the Fed's next move. Based on comments by the Fed since the meeting, it appears that they are still concerned.

The Fed surprised Wall Street Sept. 18 with an aggressive cut in its federal-funds rate, which banks charge each other for overnight loans, to 4.75% from 5.25%. . . . . In his quarterly testimony to the European Parliament committee, Mr. Trichet noted that "tensions still remain," particularly in the asset-backed commercial-paper market. But he said investors are returning to high-quality commercial paper, rather than avoiding the sector entirely. He also noted that while the profits of some banks would be hurt by the upheavals, many others are "in a comfortable position to absorb the recent difficulties," because of solid economic growth and improved risk management.

The summary of the FOMC meeting hinted that at least some of the presidents of regional Fed banks had reservations about the change to the Fed's message about inflation. The summary said that all the voting members of the committee -- the Fed governors in Washington and five of the 12 regional bank presidents -- "judged that it was no longer appropriate to indicate that a sustained moderation in inflation pressures had yet to be shown," though they agreed "some inflation risks remain."

But the summary also noted that some "participants" -- a word the Fed uses to refer to those who join the discussion even if they don't have a vote -- "remained concerned about possible upside risks to inflation." Some of the most hawkish Fed officials aren't part of this year's voting rotation but are participants in the meeting.

The FOMC minutes show that officials last month decided against explicitly saying in a post-meeting statement whether the risk of weaker growth was greater than inflation risks, "given the heightened uncertainty about the economic outlook."

Little Bits and Pieces of the News Are Signalling a Weaker Economy

In response in yesterday's post concerning the case for no recession, for which I received some angry comments and e-mails, I would like to counter this argument with little bits and pieces of the economic news that make a case for atleast a weaker economy if not a recession.

From an interview with head of YRC Worldwide (formerly Yellow Roadway), published by CNNMoney.com:

New York and most of the world get fixated on the credit crunch, since there's a tendency to be mesmerized by the financial markets. But underlying that is the real economy, which is the movement of goods. That economy is driven by people making and shipping stuff. They are not making and shipping as much [right now], and we see that every day.

How is the holiday season shaping up?

We've got a window now of about ten weeks or so where we should really see a big increase in shipment volumes as we get ready for Christmas. We have not seen that, and that's a concern. Last year's inventory buildup for Christmas was lower than historical standards, and the season ended up okay - not terrible. This year you have some easy comparisons, so you would expect to see more of a preholiday inventory buildup, but we have not seen that. Maybe it's coming later. Maybe it's not coming.

Comments from the WSJ Economics Blog concerning the Fed minutes on future corporate spending.

Businesses are expected to scale back their capital spending due to more modest sales gains and financing conditions becoming “a little less accommodative,” Federal Reserve staffers projected ahead of the central bank’s most recent policy meeting.

Economic growth forecast for the world was lowered as western economies will struggle in the rest of 2008 and 2009. From CNNMoney.com:

. . . . The new global forecast was down by 0.4 percentage point from the 5.2 percent predicted in July, before global financial markets were shaken by the fallout from the subprime mortgage lending crisis in the United States. The crisis has sparked a credit squeeze, raising the cost of borrowing.

The IMF will also cut its growth forecast for the United States to 1.9 percent from 2.8 percent previously, and for Canada to 2.3 percent from the earlier 2.8 percent, the person said. The euro zone - the 13 nations that use the euro currency, including Germany and France - is now expected to post growth of 2.1 percent in 2008, down from the 2.5 percent forecast earlier.

Europe's largest economy Germany should see 2 percent growth next year, down from the previous 2.4 percent forecast. France should also see 2 percent growth, compared with the 2.3 percent predicted previously, the person said.

The IMF also forecasts that China's surging economy will grow by 10 percent in 2008, down from the previous 10.5 percent forecast, the person said.

IMF Managing Director Rodrigo Rato had said last month that the fund would likely lower some of its 2008 economic growth forecasts to reflect the impact of financial market turbulence. He said then that its 2007 forecasts could also be revised downward.

Comments from S&P About the Housing Market – Bad News to Continue for Some Time

Comments about the housing market from the chief economist at the S&P suggests that we are still not halfway through the slump so there is more bad news to come. From CNNMoney.com:

The U.S. subprime crisis is likely to get worse, dragging down U.S. economic growth, the chief economist of Standard & Poor's said Tuesday.

"The panic has subsided but the housing market has not hit bottom yet. It will not hit bottom until winter. Housing prices won't hit bottom until next summer and the losses won't peak for another two years, until 2009," said David Wyss at a press briefing in Mumbai. "We are not halfway through this crisis yet." How can market hit bottom this winter, prices hit bottom the summer of 2008 and still be incurring losses through 2009? What about the inventory of new and existing homes on the market?

S&P forecasts the U.S. economy to grow 2 percent in 2007 and also in 2008, while the global economy is expected to grow 3.6 percent and 3.5 percent in the same period.

"We are looking at another year of sluggish growth and that's consistent with an uptick in the unemployment rate to 5 percent," Wyss said.

However, credit losses stemming from the U.S. subprime crisis have not been that great, he said.

The U.S. Federal Reserve estimates that credit losses resulting from the U.S. subprime crisis are approximately $150 billion, less than 1 percent of the $16 trillion U.S. mortgage market. This is a lot of losses to absorb. With all the announcements of losses recently, it is no where near $150B.

Wyss also said he expects the U.S. Federal Reserve to cut its funds rate by another quarter-percentage point by the end of 2007.

The Fed cut its benchmark interest rate target by half a percentage point to 4.75 percent last month after a weak August payrolls report and amid the summer doldrums in financial markets.
However, the strong September numbers and a revision in the August numbers have led some market participants to discount the chances of another rate cut in the near term.

Wyss said he expects financial markets to remain strong overall.

"If they were expecting a recession, the drop in earnings would more than offset what the Fed is doing," he said. "The fact that stock markets are strong shows financial markets are heading for expansion."

The Relative Economic Size of China

The excerpts below are from a WSJ article discussing the profitability of China. What I found interesting in the article is the tremendous size of the markets inside China.

Many foreign companies have long viewed China as a land of great potential but little immediate profit. As recently as the late 1990s, most Western marketers found this country more frustrating than fruitful.

Although better known as a prodigious exporter, China has become the world's biggest market for cellphones, with more than 500 million wireless subscribers . . . It is second to the U.S. in number of Internet users -- 162 million . . . .

China is the second-biggest market, after the U.S., for personal computers and cars. It also accounts for a huge share of the global demand for commodities such as iron ore . . .

. . . . This year, China for the first time will contribute more to global economic growth than any other country, including the U.S., according to estimates by the International Monetary Fund. With its economy expanding at a rate of more than 11% this year, China is on track to surpass Germany as the world's third-largest national economy by dollar value, although its annual output is still less than one-quarter of the U.S.'s at market exchange rates.

The Case for No Recession

Below is an article from the WSJ that basically states the case for no recession. You may not agree with the author’s premise and admittedly economist have a dismal track record when it comes to predicting recessions, but it is always worth hearing all the points of view so you can make your own decision.

With all that said note that what caused last recession may or may not have anything to do with the next recession so everyone must be careful with comparisons are not created equal.

Despite recent financial turmoil and a dismal housing market, there are key reasons why the economy will continue to expand, albeit at a modest pace, and not go into recession. Businesses are well poised to absorb a period of weaker product demand and are unlikely to significantly alter their hiring and investment behavior. Consumer spending is supported by rising incomes. Exports are strong. And monetary policy is consistent with sustained growth in domestic demand. Next year, we will look back and once again marvel at the flexibility and resilience of the economy.

To be sure, there is bad news. Housing construction and prices will continue to fall at least through 2008. There is an 18-year high in the inventory of unsold homes and soft sales that are constrained by several factors, including expectations that home prices have further to fall.

The surge in home ownership, which rose dramatically to nearly 70% in 2005 from 64% in 1994, has proved just as unsustainable as the reliance on subprime mortgages. That surge has begun to recede, and lower prices and onerous adjustable-rate mortgage resets point toward a modest further decline -- each one percentage point represents about one million homes. That decline, along with foreclosures, will elongate the housing inventory adjustment, exert downward pressure on prices, keep builders on the sidelines, and shrink employment in construction and the home finance sector.

The good news is that other factors will provide an offset. First is international trade.

Strong U.S. exports and less reliance on imports, reflecting healthy economies overseas and the weaker U.S. dollar, are boosting production and job creation here. During the housing boom years 2002-2005, residential construction added an average 0.4 percentage points per year to real GDP as the widening trade deficit subtracted 0.6 percent. That's now reversing. Since mid-2006, while the decline in residential construction has subtracted 0.9 percentage points from GDP growth, the narrowing trade deficit has added 0.5 percentage points. Expect more of the same.

Second, U.S. businesses are poised to withstand contraction.

During the late stages of prior economic expansions, as product demand slumped in response to excessive monetary restriction, firms tended to maintain production and employment growth, resulting in large inventory overhangs. Business capital spending also tended to grow too rapidly -- witness the late 1990s investment boom. Consequently, most of the decline in real GDP during prior recessions was attributable to inventory liquidation, which meant cutbacks in production and jobs, and sharp reductions in capital spending. Presently, those conditions don't exist.

Businesses in a wide range of industries outside of the housing sector have nimbly adjusted their production processes, and inventories are very lean. That significantly reduces the potential impact of any slowdown in demand on production and employment. Similarly, firms have constrained investment spending while maintaining high cash balances. Following the capital spending boom of the 1990s, the unwinding of the capital stock, net of depreciation, also lowers the probability of a jarring reduction in business investment spending.

Third, Fed monetary policy points toward sustained growth in nominal spending. Despite the financial turmoil, credit remains available to basic businesses and the vast majority of households, and a general "credit crunch" is highly unlikely to unfold.

Historically, real disposable personal income has been the dominant factor driving consumer spending. As long as businesses maintain employment, and wages continue to rise, reflecting tight labor markets, rising personal income will outweigh the negative impacts of declining home prices, declines in mortgage refinancing, and even the recent increase in energy prices, on consumption.
This assessment presumes that businesses will not cut net jobs. No doubt, jobs will be lost in some industries -- real estate, mortgage brokers and related finance, to name a few. But that's minor in the context of 138 million U.S. workers.

Fourth, my discussions with a wide array of business executives in an assortment of non-financial industries suggest that they have not materially altered their hiring plans, despite heightened concerns about general economic conditions. The majority plan to maintain employment levels or increase them in the next year, with most of the planned increases in export and international-related activities. September's reported rise in employment, covering the period of maximum financial crisis, is encouraging.

Once again, turmoil on Wall Street doesn't necessarily translate to contraction on Main Street.
Remember, following both the stock market crash of 1987 (which involved a cumulative 35% decline in equity valuations) and the 1998 financial crisis, the economy continued to expand. In both cases the Fed eased, financial markets absorbed the shock, and the economy proved resilient. The same will unfold this time; recession is not in the cards.

Are Investors Rational – Probably Not?

Allow me to preface my comments with the following – I usually do not give out investment advice, however, periodically an article comes along that needs to be read.

Are investors rational? Probably not. If you don’t believe this statement than explain to me why it makes good financial sense to buy a house in today’s market. If they are not rational can they be taken advantage of by people who understand this? What do you think?

Based on e-mails and comments I received recently, there are a lot of questions about how rational the stock market is given housing crash, capital markets, slowing consumer spending, etc. The article below from Market Watch asks the same question. In addition, the article has suggested reading on behavior finance and neuroeconomics. If you believe there is a difference between smart money and the rest of us, or you are afraid of the effects of the increasing power of “black pools”, you may want to read some the suggested books before dropping a pile of money into the market.

Want to learn how to harness your brain power and get rich? Well, folks, there are two basic minicourses covering the mysterious world of the investor's brain, also known as behavioral finance or neuroeconomics or just plain investment psychology.

Here are the two courses: First for beginners: "Behavioral Finance 101: The Myth of the Rational Investor." Second, the graduate level course, "Behavioral Finance 602: The Secret to Beating America's 95 Million Irrational Investors."

Take one course or both. Your choice will depend on how you answer this quirky question: "Can you fix a broken machine with broken tools?" Stick with me because your answer will reveal your chances of becoming one of America's 8 million millionaires.

First off, here's Course 101 in a nutshell, using a key passage from Money magazine columnist Jason Zweig's brilliant new book, "Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich:"

"Your brain is a superbly functioning machine, steering you away from danger while guiding you toward basic rewards like food, shelter and love ... But that brilliant machine can lead you astray when it comes to investing. You buy high only to sell low. You try to time the market. You follow the crowd. You make the same mistakes again. And again. How come?"

Stop. Notice two crucial neuroeconomics definitions: First, your brain is a "machine." Second, when investing, your brain is a "broken machine."

That's right, your brain is a saboteur. So the goal of Course 101 is fixing your broken machine (your brain). Warning: The saboteur remains, so you end up with a "less-broken machine," not a rational investing "machine." Why? Because your emotions run the rational brain. At best, you're a little "less irrational," but not rational.

Investors place too much faith in neuroeconomics. As Zweig points out, this new science gained credibility when Princeton University psychologist Daniel Kahneman won the Nobel Prize in Economics five years ago. Today neuroscience is "making stunning discoveries about how the brain evaluates rewards, sizes up risks and calculates probabilities."

Actually, Kahneman and other neuroscientists have been making discoveries for several decades, disproving Wall Street's bogus "rational investor" theory, Zweig says ,thanks to:

"The wonders of imaging technology [with which] we can observe the precise neural circuitry that switches on and off in your brain when you invest. Those pictures make it clear that your investing brain often drives you to do things that make no logical sense, but make perfect emotional sense."

Today experts looking at brain-images see that "your brain has only a thin veneer of modern, analytical circuits that are often no match for the power of the ancient parts of your mind."

When you invest "you stir up some profound emotions," and "understanding how those feelings -- as a matter of biology -- affect your decision-making will enable you to see as never before what makes you tick, and how you can improve, as an investor."

In a nutshell that's Course 101: Once you realize what "makes you tick" you will behave "less irrational" and become a rich investor. The goals of Course 101 are: (1) Become fully aware of your sabotaging behavior; (2) Follow neuroscience's new rules; (3) Behave "less irrational;" (4) Make more money playing the market.

And so, dear students, I urge you to round out your understanding of Course 101 by reading these works:

• "Investment Madness," by Prof. John Nofsinger (2001) of Washington State University, a behavioral-finance guru who has written several key books on the field including, "The Psychology of Investing," a widely used textbook for professionals, and "Investment Greed," about the stock market scandals and others.
• "Mind Over Money," by John Schott (1998), a Harvard Medical School psychiatrist, behavioral-finance expert and portfolio manager.
• "Investment Therapy," by Richard Geist (2003), another Harvard Medical School psychiatrist and president of the Institute of Psychology and Investing.
• "Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing" (2000), by Prof. Hersh Shefrin of the Santa Clara Business School, also editor of the three volume collection "Behavioral Finance."

Now for the second course: "Behavioral Finance 602: The Secret to Beating America's 95 Million Irrational Investors." The popular text is Yale economist Robert Shiller's "Irrational Exuberance," which was published just as the 1990s insanity peaked and collapsed into a three-year bear/recession.

Shiller says "irrational exuberance" is "wishful thinking on the part of investors that blinds us to the truth of our situation." And you can't "fix" it. Bull/bear cycles will forever drive markets to extreme highs (greed) and extreme lows (fear). Why? Because emotions, not rational behavior, drive Main Street investors.

We'll never become "less irrational" because trying to fix a "broken machine" with neuroscientific rules is a "wishful thinking" strategy, to use Shiller's description.

So now you know how neuroscience differs in 101 versus 602. Neuroscience is a "broken tool" when used to help individual investors become "less irrational," the goal of 101. However, neuroscience is an extremely powerful tool when used by Wall Street insiders (bankers, portfolio managers, brokers, quants and their friends) as a weapon against America's 95 million investors, to manipulate, dominate and control them. Shiller puts it in simple terms: "Deep down, people know that the market is highly priced, and they are uncomfortable about it. Most people I meet ... are puzzled ...We are unsure whether the market levels make any sense. ... We are unsure whether the high levels of the stock market might reflect unjustified optimism, an optimism that might pervade our thinking and affect many of our life decisions. We are unsure ..."

Flash forward. Today, Shiller sees the cycles of greed, fear, overoptimism and panic again peak and collapse in the recent housing/credit bubble. Endless cycles of irrational exuberance will repeat again and again and again, ad infinitum. Why? Because investors really don't want to or cannot fix their broken machines.

But there is an even more sinister reason 101 doesn't work. And that's also the force driving "Behavioral Finance 602. Get this: Wall Street's insiders have been "taking" Course 101 for decades. They already know America's irrational investors will never become "less irrational."
Instead, hotshot neuroeconomists are developing computer models describing the irrational behavior of irrational investors. And they're using knowledge to their advantage. As University of Chicago behavioral finance guru Richard Thaler says: Wall Street "needs investors who are irrational, woefully uninformed, endowed with strange preferences, or for some other reason willing to hold overpriced assets."

So the new gurus of behavioral finance who invented Course 602 are now working for Wall Street insiders against Main Street's irrational investors, and making big bucks. They want investors to stay irrational. They have no intention of helping investors become "less irrational."

They are using their new strategies and technologies to map out the behavior "coordinates" of irrational investors, so they can attack like a stealth bomber under the radar and take full advantage of irrational investors. Want more? Read all about how neuroeconomists are beating America's gene pool of 95 million irrational investors in:

• "Capital Ideas Evolving," by Peter Bernstein
• "Mean Markets and Lizard Brains," by Terry Burnham
• "Fooled by Randomness," by Nassin Nicholas Taleb

Discover the magic of Course 602, if you build a career on it you'll be on your way to becoming a multimillionaire early. Learn the basics in Course 101 and maybe you'll become millionaire by the time you retire, maybe.

I am currently in the process of reading "Fooled by Randomness" and it is the best book I have read on the stock market since "Random Walk Down Wall Street".

This Weekend's Contmeplation - It Is Always Good to Get Some Historical Perspective

The article below from the WSJ gives an interesting prespective on some ideas that were popular 35 years ago and where they are today. I remember using the "Limits of Growth" and the "Population Bomb" as textbooks in graduate school in the the 1970s. Sometimes it is good to compare your ideas from 30 years ago to what is happening now.

I'm old enough to recall the days in the late 1960s when people wore those trendy buttons that read: "Stop the Planet I Want to Get Off." And I will never forget that era's "educational" films of what life would be like in the year 2000. Played on clanky 16-millimeter projectors, they showed images of people walking down the streets of Manhattan with masks on, so they could avoid breathing the poison gases our industrial society was spewing.

The future seemed mighty bleak back then, and you merely had to open the newspapers for the latest story confirming how the human species was speeding down a congested highway to extinction. A group of scientists calling themselves the Club of Rome issued a report called "Limits to Growth." It explained that lifeboat Earth had become so weighed down with humans that we were running out of food, minerals, forests, water, energy and just about everything else that we need for survival. Paul Ehrlich's best-selling book "The Population Bomb" (1968) gave England a 50-50 chance of surviving into the 21st century. In 1980, Jimmy Carter released the "Global 2000 Report," which declared that life on Earth was getting worse in every measurable way.

So imagine how shocked I was to learn, officially, that we're not doomed after all. A new United Nations report called "State of the Future" concludes: "People around the world are becoming healthier, wealthier, better educated, more peaceful, more connected, and they are living longer."

Yes, of course, there was the obligatory bad news: Global warming is said to be getting worse and income disparities are widening. But the joyous trends in health and wealth documented in the report indicate a gigantic leap forward for humanity. This is probably the first time you've heard any of this because -- while the grim "Global 2000" and "Limits to Growth" reports were deemed worthy of headlines across the country -- the media mostly ignored the good news and the upbeat predictions of "State of the Future."

But here they are: World-wide illiteracy rates have fallen by half since 1970 and now stand at an all-time low of 18%. More people live in free countries than ever before. The average human being today will live 50% longer in 2025 than one born in 1955.

To what do we owe this improvement? Capitalism, according to the U.N. Free trade is rightly recognized as the engine of global prosperity in recent years. In 1981, 40% of the world's population lived on less than $1 a day. Now that percentage is only 25%, adjusted for inflation. And at current rates of growth, "world poverty will be cut in half between 2000 and 2015" -- which is arguably one of the greatest triumphs in human history. Trade and technology are closing the global "digital divide," and the report notes hopefully that soon laptop computers will cost $100 and almost every schoolchild will be a mouse click away from the Internet (and, regrettably, those interminable computer games).

It also turns out that the Malthusians (who worried that we would overpopulate the planet) got the story wrong. Human beings aren't reproducing like Norwegian field mice. Demographers now say that in the second half of this century, the human population will stabilize and then fall. If we use the same absurd extrapolation techniques demographers used in the 1970s, Japan, with its current low birth rate, will have only a few thousand citizens left in 300 years.

I take special pleasure in reciting all of this global betterment because my first professional job was working with the "doom-slaying" economist Julian Simon. Starting 30 years ago, Simon (who died in 1998) told anyone who would listen -- which wasn't many people -- that the faddish declinism of that era was bunk. He called the "Global 2000" report "globaloney." Armed with an arsenal of factual missiles, he showed that life on Earth was getting better, and that the combination of free markets and human ingenuity was the recipe for solving environmental and economic problems. Mr. Ehrlich, in response, said Simon proved that the one thing the world isn't running out of "is lunatics."

Mr. Ehrlich, whose every prediction turned out wrong, won a MacArthur Foundation "genius award"; Simon, who got the story right, never won so much as a McDonald's hamburger. But now who looks like the lunatic? This latest survey of the planet is certainly sweet vindication of Simon and others, like Herman Kahn, who in the 1970s dared challenge the "settled science." (Are you listening, global-warming alarmists?)

The media's collective yawn over "State of the Future" is typical of the reaction to just about any good news. When 2006 was declared the hottest year on record, there were thousands of news stories. But last month's revised data, indicating that 1934 was actually warmer, barely warranted a paragraph-long correction in most papers.

So I'm happy to report that the world's six billion people are living longer, healthier and more comfortably than ever before. If only it were easy to fit that on a button.

New Funding for the Consumer – Their 401(k)??

According to the WSJ, there appears to be an increase in borrowing from 401(k)s. It appears to be small, but is noticeable. This article is especially good because it does not go into all the “preachy” stuff about why you should not borrow from a 401(k). Instead it dwells on the tax consequences of borrowing from your 401(k). Those alone should scare you into not borrwoing from your 401(k).

Despite potential tax and investment consequences, more individuals have been borrowing from their 401(k) plans or taking hardship withdrawals in recent months, some retirement-plan providers say.

Not all plans have seen jumps, and more-comprehensive statistics won't be available until next year. But a number of plan providers that follow month-to-month patterns, including T. Rowe Price Group Inc., Hewitt Associates and Hartford Financial Services Group Inc., have seen a small but noticeable uptick.

Many in the field expect more 401(k) borrowing in 2008 as consumers struggle with tighter credit and potentially higher mortgage payments.

"I don't think it's a groundswell, but it's enough to be noticed," says Rick Meigs, president of 401khelpcenter.com, which provides information on 401(k) plans.

To be sure, the indications are preliminary, and some big providers, such as Fidelity Investments, say they haven't seen any increase in 401(k) borrowing. About 20% of Fidelity 401(k) investors have a loan, a figure in line with the industry. (my emphasis, why am I surprised the number is that high.?)

Even those firms that are seeing increase in 401(k) borrowing aren't sure what to ascribe it to, though financial advisers say it could be due to the effects of the credit crunch and slumping housing prices.

"A few years ago, the buzz was about borrowing from a 401(k) to buy a second home," says Jeff Carbone, a financial adviser in Cornelius, N.C. "Now it's people looking at their 401(k) because they've extended themselves on their homes and credit lines."

Most plans allow borrowers to take money out of their 401(k) accounts to pay tuition, purchase a residence, pay medical or funeral expenses, or to avoid eviction or foreclosure. Borrowers must repay the loan plus interest, which is typically set at one or two percentage points above the prime rate.

While plans vary, the most you can borrow is the lesser of 50% of your vested balance or $50,000.

Employees usually must repay money borrowed for a mortgage within 15 years, and money used for other purposes within five years. If you fail to pay back the loan on time and are younger than 59½, you're subject to regular income tax and an IRS penalty tax of 10% for early withdrawal.

Though borrowing against your retirement nest egg may seem tempting, it could significantly reduce your savings at retirement and create an expensive tax bill if you can't repay the loan when it is due.

Tom Foster, a national spokesman for Hartford's retirement plans, says that he considered borrowing from his 401(k) when he was saddled for more than a year with an extra mortgage, but decided against it.

"Most Americans see this as a panacea, but instead it erodes time in the market and adds a new payment," he says.

Even a person who pays such a loan back on time, and therefore avoids the 10% penalty, is getting taxed twice, says Bill Arnone, a partner at Ernst & Young LLP -- once when repaying the loan with after-tax dollars, and a second time when the money is withdrawn at retirement. (my emphasis)

People who take the loans also lose out on potential retirement earnings while the money isn't invested.

Should you lose your job, the costs could be even higher. Borrowers who are fired, laid off or quit typically have to pay off the loan within 90 days, or face additional taxes and penalties, says Stuart Ritter, a financial adviser at T. Rowe Price.

David Wray, president of the Profit Sharing/401(k) Council of America, a not-for-profit association of companies that sponsor plans, expects that higher payments on adjustable mortgages will have people "looking for ways to make up that gap," and "a significant number of people with 401(k) plans are going to be affected."

What is a Black Pool and What is the Effect on the Common Investor?

Excerpts below from an article in Business Week, describes trades between brokerages without going through the traditional stock market. Black pools have good points for large trades, specifically privacy and cost. A bad point is that ultimately it raises questions about the meaning of publicly traded securities. This post is long, but is worth a read, especially if you are active in the stock market.

It's not easy being a big player in the stock market. Trading huge quantities of stock on traditional exchanges has become ever more challenging, costly, and potentially disruptive. And if other players see your moves, they can disrupt your trades. That's led to the emergence in recent years of alternative trading systems known as dark pools. And their growth could have significant implications for big stock exchanges—and individual investors.

Dark pools sound like something from Greek mythology or a sci-fi epic, but in stock-market speak they are private trading networks that big brokerages such as Lehman Brothers and Merrill Lynch have developed primarily for the internal matching of orders between buyers and sellers who are clients of the same brokers. But dark pools have developed links among Wall Street firms as well, so that orders can be matched across different brokerages. Indeed, some firms are teaming to launch new dark pools such as BIDS Trading.

Alternative trading systems, or ATSs, have gained an increasing share of equity trading in the past few years. In addition to dark pools, ATSs include crossing networks, such as independently owned Liquidnet and Pipeline, that match orders for execution without having to first route them to an exchange or market center where they could be viewed publicly. Besides enabling investors to execute an order without affecting the public price quote, crossing networks match orders at a specified price, typically the midpoint of the bid and ask prices on stocks at the point in time of the trade. Electronic communications networks (ECNs), which trade stocks and currencies, are another type of ATS.

The initial proliferation of ATSs stemmed from policy changes by the U.S. Securities & Exchange Commission that were designed to encourage competitive pricing. More recently, the motivation for using them has been the quantities of stock being traded and the ability to keep these transactions hidden—and anonymous. Dark pools also make it easier to trade small- or mid-cap stocks, which are often lower-profile companies that, because they're less liquid, are harder to trade publicly.

When New York-based Liquidnet launched in April, 2001, block trades of 10,000 shares or more represented 60% of the New York Stock Exchange's total trading volume and currently account for only 18%, says Alfred Eskandar, who heads Liquidnet's corporate strategy group.

Much of that decline in volume is tied to a change in the way prices of NYSE-listed stocks are expressed, from fractions to decimals, starting in 2001. With stocks priced in cents, instead of sixteenths, it's less likely that an investor will find a buy or sell match for his order at a price both sides can agree on, which has thinned block trading volume.

In a September, 2007, report, Aite Group, an independent research firm in Boston, predicted that exchanges' market share in U.S. equity trading would continue to decline from the current 75%, before stabilizing at around 62% by 2011. The formation of 35 to 40 ATSs has exacerbated fragmentation of the marketplace. (my emphasis)

It's not just the faster processing speed that has lured institutional investors with their jumbo trades to ATSs, but lower trading fees. The difficulty of finding the necessary liquidity to match big-block orders forces traditional exchanges to slice and dice an order of 100,000 shares into smaller chunks of a few hundred shares each that are then executed at a range of different price points.

Eskandar calls Liquidnet a wholesale trading community, which gives investors a break on transaction costs because they're trading such huge quantities. "It doesn't make sense when wholesalers pay a premium for something," he says. "Institutions should benefit from their large size."

On average, Liquidnet charges customers 2¢ per share, with no volume discounts. Given that the average trade size on Liquidnet is 52,000 shares, that's a bargain, says Eskandar. Commissions are the same at Pipeline and ITG POSIT, one of the first crossing networks, whereas BIDS (Block Interest Discovery Service) charges half a penny per share, the Aite report said.

Liquidnet operates by embedding its software into institutional investors' desk-top order management systems. The software essentially scans a customer's electronic trading blotter for buy or sell orders, which then pop up on the Liquidnet screens only of other customers whose blotters have comparably sized opposing-side orders of the same stocks.

"We're not soliciting merchandise that [institutional investors] are not interested in, so there's no noise," Eskandar says. "We're simply giving information based on the information they share."
The growing use of alternative platforms has traditional exchanges scrambling to come up with ways to preserve their market share.

In the past year and a half, the NYSE has snapped up Archipelago, an ECN, and converted it into its electronic Arca exchange. It has also merged with Euronext, a European exchange, enabling NYSE members to trade foreign stocks. In addition, it bought a 5% stake in India's National Stock Exchange and has entered into a strategic alliance with the Tokyo Stock Exchange.

Yet, even as it expands into other markets, the Big Board is closing two of its four remaining physical trading rooms by November, and increasing rebates to traders who post bids or offers on the Arca system by 25% in an effort to protect its piece of the equity-trading pie.

Its biggest move to stem the tide of trading volume to other venues may be MatchPoint, its own crossing system for big-block trades, which it plans to roll out in October or November, pending approval from the SEC.

Instead of the continuous crossing that most ATSs provide, MatchPoint will offer a series of scheduled crossing sessions, probably every hour on the hour during the regular trading day.

Jim Ross, who created MatchPoint and developed many crossing features at Instinet during the 14 years he worked there, believes that by amassing liquidity over time, the NYSE will be able to accommodate bigger blocks than a single-point continuous crossing system. While orders accumulate, all information is hidden and there's no interaction between participants, but users are able to edit, cancel, or add orders to the system. Orders become firm at the appointed match time and are matched on a pro-rated basis according to size using a national-best-bid-and-offer price derived from an external data provider.

A new securities regulation known as Reg NMS has leveled the playing field by requiring that all trading venues ensure the best execution of trades. The changes, which went into effect in December, 2006, were a catalyst for the formation of more of these alternative venues, which recognized that orders would find them as long as they could compete on price, says Bill Cline, chief executive of Acai Solutions, a capital markets consultancy in New York.

"Anyone who thinks [ATSs aren't] a threat to traditional exchanges' volume in cash equities is probably wrong," Cline adds.

Driving investors' quest for greater anonymity and lower market impact costs are their well-founded fears that information was leaking whenever they placed orders with sell-side brokers, which prevented them from getting the best execution on their trades, says Cline. That's why Liquidnet remains essentially a club for buy-side investors only. And even if its H20 model lets in selected sell-side brokers, it's only to add liquidity to the pool for its buy-side members, not to give sell-side participants equal access to buy-side order flow.

Probably because it was founded by some of the biggest brokerages, BIDS Trading doesn't believe in barring sell-side players. The more participants invited in, the better the chances of matching buy and sell orders, says BIDS Chief Executive Tim Mahoney.

Instead, BIDS provides score cards that track users' past trading behavior and enables members to filter out counter-parties whose behavior is suspect. For example, members can limit users they're willing to trade with to those with a record of completing most of the trades they've entered into. "If you were going to discriminate against someone, you should discriminate based on their behavior, not on whether they're on the sell-side or buy-side," Mahoney says.

MatchPoint's solution for preventing order leakage is its point-in-time, or scheduled, crossing system, which makes it harder for would-be predators to identify where individual orders are within the system, Ross says. That keeps the predator from jumping in with his own order elsewhere and disrupting the intended trade.

The proliferation of dark pools could have ripple effects beyond just block trading, says Lee at Aite Group. As long as they remain a niche market, they're probably of little consequence. But if the equities market becomes increasingly dark as more trading shifts to these platforms, while retail investors continue to see only the public portion of equity trading, it calls into question the actual meaning of public price quotes, Lee says.

On a practical level, if retail investors get the price they think they'll get when they submit an order and they're happy about it, they probably wouldn't care what the actual reality of the marketplace is, he says.

Regulators would care, however, regardless of whether individual investors have concerns. In fact, Reg NMS modified a 1997 regulation by lowering from 20% to 5% the ceiling on average daily volume of any given stock that ATSs are permitted to represent before being required to disclose information to the public market, Lee says.

Cline believes that not only are dark pools ultimately a good thing for investors but that "to not take advantage of dark pools is failing to live up to the best execution mandate of Reg NMS."
Whatever their advantages, it seems clear there isn't enough liquidity available for all of the alternative trading venues to survive in the long run. There's already been some consolidation, and more is sure to follow.

In the battle for market share, the exchanges are in a better position than ATSs because they have other revenue sources, such as market data and stock listings, that allow them to be more aggressive on pricing, says Lee.

When NASDAQ came under attack by ECNs, it slashed its prices for a while to attract customers and its market share stabilized. And just as NASDAQ ended up buying some ECNs to boost its market share, Lee says he wouldn't be surprised if ATSs become buyout targets for the big exchanges. But for now, more Wall Street players may decide to test the waters of the dark pools.

De-Coupling Appears to be Well Underway, But How Secure Is It?

The issue of de-coupling of the world economies from the US economy appears to be well underway, from the WSJ. The real question is as the US economy continues to slow, what will be the effect on the economies outside the US. This is the true measure of de-coupling. None the less, if the US economy weakens considerably as many anticipate, de-coupling will be fairly complete within five years. Other countries will develop other trading relationships and other currencies will become dominant in response to the weakness of the US economy.

Any investors putting money on the "great decoupling" should know one thing: They aren't the only ones laying down chips.

It's increasingly clear that the U.S. isn't any longer the sole engine of global growth -- that other economies have, in effect, decoupled from it. Witness current events: The U.S. economy is getting buffeted by the housing downturn, but so far the world economy seems to be in fine fettle.

There are plenty of reasons. In Europe, economic overhaul, the adjustment to the adoption of the euro and the process of integrating the old East Germany into the German economy may have finally paid off, putting an end to the long era of subpar growth.

In China, the rise of a consumer class means its rapidly growing economy is no longer as dependent on exports. Even Japan has held up well, which is pretty impressive after its scandal-ridden government told households it had lost 64 million national pension records.

Among the signs that other countries are weathering the U.S. weakness: Oil prices are high -- and not just in dollar terms -- signaling strong global demand. The Baltic Dry Exchange index, which measures shipping costs for bulk commodities, is at a record high, indicating global demand for things like coal and iron ore remains healthy. Seoul's stock market, a proxy for global growth because of South Korean firms' export role, has been surging: The Korea Composite Stock Price Index is up 40% this year. Finally, the dollar's weakness may be a sign of better times overseas.

For U.S. investors looking to cut exposure to a weaker U.S. economy, the key is to find companies that benefit from global growth and avoid those that are domestically focused or have big exposures to the housing market.

Strong global demand makes energy and basic-materials companies obvious bets, particularly since oil and raw materials are good hedges against a weakening dollar. Industrial companies with big overseas sales, such as Boeing and Deere, also make sense, as do most technology firms.

On the other side of the ledger, department stores, media companies, restaurants and other so-called consumer-discretionary companies could get hurt by a slowdown in consumer spending at the same time that they see some of their costs driven higher by the global boom. Many regional banks and other financial companies are getting hit by mortgage trouble. Firms with exposure to housing (builders, building-supply companies) are in the worst straits.

Perhaps the biggest problem with all this is that plenty of people have already thought of it: If you tried to lift a stack of all the Wall Street reports that mentioned "decoupling" in the past few months, your back could be in trouble.

In fact, the share prices of companies with the biggest overseas exposure have been among the best performers lately.

There's a big hidden risk here. When so many investors place bets on the same idea -- no matter how good it is -- even the slightest bit of unexpected bad news can inflict widespread pain as everyone tries to unwind those trades.

The question that the author is asking is if the economies outside the US begin to weaken in response to a weakening US economy, will everyone head for the exit at one time. This is the $64,000 question isn’t it. What is your bet?

The Stock Market – It May Not Be the Real Deal

Once again I would like to make some comments about the stock market. Please note that I do not give out investment advice. The purpose of my comments are to stimulate conversation and contemplation.

Based on comments on a number of posts, a couple of articles in the WSJ (#1 and #2), and response to an earlier post I began to question why the market is moving up in light of the economic and market news. For a stock market to be considered a “real” rally the increasing market has to be broad based with increasing or high volumes.

First the Economic and Market News Isn’t Good:

It is now clear that the housing market is in free fall. When commentators start saying things like the market will not turn around for another 12 – 24 months or existing house owners need to drop their prices to move their houses, things are not good and are not getting better next week.

Capital markets, except for the very high grade debt, continue to struggle with liquidity and confidence issues.

Banks, both the US and overseas, and investment banks are beginning to report large losses due to the write down of mortgage debt.

Job creation is slow in the US.

The dollar is reaching all time lows against the euro. Other countries are beginning to relinquish their need to hold US Treasuries as a reserve currency.

To Test the Strength of the Market:

To address this question I once again went back to my simple minded indices that I developed to address the issue of how the retailers were doing. After all, if the stock market was up but the retail component is lagging the market clearly does not think the retail sector will do that well in the near term. If the retail sector is a surrogate for consumer spending, maybe the market is not really that confident about the strong economic growth in the near term. Just maybe all recent increases in stock prices are caused by the euphoria of a rate cut and have nothing to do underlying fundamental strength of the economy.

To test this idea I created a simple index, using June 1, 2007 as a base, so the S&P 500 index could be compared to the S&P Retail Index.

The two graphs below were first published on September 24 and not much has changed. Updates of the graphs to October 1 data does not indicate any improvement. If anything things may have deteriorated somewhat.

The first graph below clearly shows that although the S&P 500 has had its ups and downs since May, the index is only slightly off the highs sustained through May, June and July. The S&P Retail Index is, however, a different story. The Retail Index also had its ups and downs in May, June, and most of July, but beginning in late July the index began to decline from the base period. More importantly, although the index has recovered from its lows in mid-August it has not recovered as much as the S&P 500 index over the same period. As a matter of fact if the difference between the two indices is calculated it clearly indicates that the S&P 500 is recovering much more quickly than the Retail Index (graph two). (Double click on the graph for a larger image.)









Although this is not proof positive that the current market trend is not a widespread rally it certainly suggests that some sectors of the economy are lagging. By the way, if you compare the returns of the Dow Jones Industrial Average (DJIA) to the S&P 500 you will note that the DJIA has outperformed the S&P 500, indicating that what we are seeing may be a flight to safety and not a broad based rally.

The second test of market strength is to look at volume. Once again a simple index of the DJIA and its associated volume was developed using June 1, 2007 as the base. The graph below indicates that the rise in stock market prices did not have an associated increase in volumes indicating that the stock market rise lacks strength. (Double click on the graph for a larger image.)

The stock market rise since the Fed rate appears to lack a broad base and lacks volume, suggesting that this rise is anemic and may not be sustainable.

Oil at $100+/barrel?

Recently more articles like the one below from Market Watch have been appearing in the news. I am not sure if $100/barrel will occur early next year as the article suggests. But $100 oil is more probable than $40/barrel oil. We really are in a period where demand is outstripping supply. Looks like Peak Oil is here.

Oil prices of at least $100 a barrel are expected to become the norm as early as next year, as conventional supplies continue to decline and consumption in the developing world rises, CIBC chief economist Jeff Rubin said Tuesday.

"We're in a world of triple-digit oil prices for the foreseeable future," Rubin said at the CIBC 2nd Annual Industrials Conference. "Whether it's $100 or $140 a barrel ... is up to debate, but the bottom line is we're in the bottom of the ninth inning of the hydrocarbon age."

Rubin said higher oil prices will spur technological innovations, as well as growth in nuclear power and biofuels.

"I'm not sure in 50 or 60 years, oil will still have the role in the global energy market that it does today," he said.

Rubin said more of OPEC's production will go toward fueling its own energy needs.
Despite Wall Street's obsession with oil consumption by China and India, oil use in Russia, Mexico and the OPEC nations outpaced the world's most populous country last year.

In Venezuela and Saudi Arabia, for example, the retail cost of gasoline ranges around 25 cents a gallon -- cheap enough to consume in ever-larger quantities to fuel growth.

At the same time, oil-rich countries such as Kuwait and Mexico are starting to see declines in major oil field supplies, he said.

By 2012, Canadian oil sands could become the single largest source of new oil supply for the U.S. as Mexico's supplies become depleted, he said.

Six of the largest oil suppliers to the U.S. are poised to cut their global exports by nearly 2 million barrels a day by 2012, Rubin said.

The projected cut -- amounting to 7% -- by Mexico, Saudi Arabia, Venezuela, Nigeria, Algeria and Russia, "reflect the growing struggle in these countries to grow production and manage their own soaring rates of oil consumption," Rubin said.

Canada's oil sands production is expected to increase to 2.3 million barrels a day by 2015, up from about 1.1 million barrels a day in 2005, according to the U.S. Energy Information Administration.

Why the US Dollar Will Continue Its Downward Trend

The following from the WSJ discusses why the US dollar will continue its downward trend. This is not necessarily a bad thing. We will all get stung by inflation from imports, but maybe a lower dollar will strengthen the manufacturing sector for exports and reduce the number of jobs going overseas. A strong currecny is not always what it is cracked up to be.

America's heady deficit with the rest of the world has long looked like an accident waiting to happen. With the dollar's recent slide, it doesn't look like it's waiting anymore.

If such alarmism sounds familiar, it should. In 2004, the dollar was falling amid mounting worries about America's trade imbalance with the rest of the world. That year the U.S. current-account deficit -- a broad measure of the trade imbalance -- swelled to $640 billion, or 5.1% of gross domestic product.

Nouriel Roubini and Brad Setser, two academics who predicted a sharp decline in the dollar, became required reading on Wall Street desks.

Then in 2005, when everyone seemed to agree the dollar would fall further, it rallied instead. That put a temporary end to Wall Street's current-account obsession and singed a few hedge funds in the process.

Why should this time be different?

Worries about the current-account deficit have been popping up in currency markets for years. Broadly speaking, the deficit measures how much more the U.S. spends on goods and services from abroad than it earns on the goods and services it sells. To cover the difference, the U.S. is, in effect, borrowing from other countries. If they tire of this routine, they'll expect America to write bigger IOUs. The easiest way for that to happen is through a weaker dollar.

In practice, it seems like the current account is often just an after-the-fact explanation for declines in the dollar. The dollar bounces, and then something else grabs the market's attention.

What's different now, says Harvard University professor Kenneth Rogoff, is that the U.S. economy is looking weaker than many of its counterparts abroad.

At the moment, that's largely a housing story. In the longer term, he thinks it's also a productivity story. For a decade, heady U.S. productivity gains meant the U.S. economy could grow faster without fueling inflation -- a key reason for why it became such an attractive investment destination and why that unsustainable current-account deficit was sustained.

Now, productivity growth in the U.S. appears to be slowing. At the same time, the rest of the world has been adopting the technology and practices U.S. companies pioneered, boosting productivity abroad.

That means U.S. growth may be slower relative to that in other countries for some time, with the upshot that investing in the U.S. -- put another way, buying U.S. IOUs -- won't be as attractive as it once was.

In addition to pushing the currency lower, foreign investors could force U.S. interest rates higher relative to the rest of the world. Already, the spread between emerging-market bonds and U.S. Treasurys has narrowed substantially. They could also reduce the premium they'll pay for U.S. stocks relative to other stocks.

In late 2005, Mr. Rogoff and Berkeley professor Maurice Obstfeld calculated that the current-account adjustment could push the dollar down by 30% against the Fed's weighted basket of U.S. trading partners' currencies. Since then, it's fallen 11%, leaving about 20 percentage points to go. But rather than the sudden drop that current-account Cassandras sometimes envision, he expects the decline to be gradual.

"We're only going to see a radical adjustment if the U.S. tips into recession," he says.

A Rare Look At How The Fed Operates

Excerpts below from an article in Bloomberg, gives an indication of conversations that Ben Bernanke had in August with various “generals” in the finance industry. Most people familiar with the Fed know these conversations take place all the time, but this article details who Dr. Bernanke talked to, not what they talked about. It is clear from the discussions that took place that there was a lot of “huddling” about the condition of the capital markets, which presumably led to his actions in mid-August. I noticed that there were no conversations mentioned with central bankers in England, the euro zone, or Asia. The moves of the central banks were too similar and coordinated to leave them to random luck.

Starting with a phone call from former Treasury Secretary Robert Rubin the day after the August rate meeting, Bernanke's appointments included Lewis Ranieri, founder of Hyperion Capital Management Inc., and Raymond Dalio, president of Bridgewater Associates.

The information on Bernanke's calls and contacts was obtained under the Freedom of Information Act by Kenneth H. Thomas, a lecturer at the University of Pennsylvania's Wharton School in Philadelphia. The records depict a chairman who ``has made a very good effort to get up to date with what is going on,'' Thomas said.

David Skidmore, a Fed spokesman in Washington, confirmed the authenticity of the document provided by Thomas to Bloomberg News. He said he couldn't provide details of discussions that Bernanke, 53, had with Rubin and others.

The conversations came against the backdrop of the worst global credit rout in almost a decade. After $38 billion in cash injections into the banking system failed to boost liquidity, the Fed on Aug. 17 cut its discount rate by half a percentage point, to 5.75 percent, and signaled a September reduction in the benchmark federal funds rate. The Fed cut the key rate a half-percentage point to 4.75 percent on Sept. 18.

Rubin, 69, now chairman of the executive committee at Citigroup Inc. in New York, told Bernanke that the Fed made the right decision on Aug. 7, even as traders complained the central bank was oblivious to weakening markets, according to a person familiar with the conversation.

On Aug. 9, Bernanke met from 11 a.m. to noon with Ranieri, a former vice chairman of Salomon Brothers Inc. and a pioneer in the mortgage-backed securities market. Fed Governor Randall Kroszner and Community Affairs Director Sandra Braunstein, who also runs an enforcement team, joined the conversation with Ranieri. Ranieri, 60, wasn't available for comment.

Dalio visited Bernanke at 2 p.m. the same day. Bridgewater is the fourth-largest U.S. hedge fund firm, with $32.10 billion in assets under management as of July 1, according to HedgeFund Intelligence's Absolute Return magazine.

According to the Fed records, Bernanke consulted throughout the month with staff experts, investors, congressional officials, community groups and Bank of England Governor Mervyn King.

Bernanke and King spoke by telephone at 1:30 p.m. on Aug. 17, following the U.S. discount-rate cut that morning. Bernanke was also in frequent contact with Treasury Secretary Henry Paulson, who said in an interview last month that he meets the chairman regularly.

Bernanke's schedule lists 35 Fed conference calls from Aug. 9 to Aug. 31, including at least two during the central bank's summer retreat at Jackson Hole, Wyoming. During the first full day of the symposium, Bernanke said in a speech that he would do what was needed to keep the six-year economic expansion going.

On the eve of the Aug. 7 rate decision, Bernanke received a briefing from Fed staff on markets. He also spoke with Timothy Geithner, president of the Fed's New York branch and the central bank's chief liaison with Wall Street.

In the days after the rate meeting, as Bernanke touched base with executives and investors, credit costs climbed. The Fed added more reserves to the banking system than any time after the terrorist attacks of Sept. 11, 2001, in an attempt to increase liquidity.

Yield differences between high-grade debt and riskier credit widened, according to a macroeconomic risk index tracked by Citigroup Global Markets. The index rose to 0.98 on Aug. 17, with a reading of one being a measure of high risk aversion, up from 0.89 on the day before the rate decision.

Wayne Passmore, a Fed expert on mortgage finance, met with Bernanke at least four times in August, including before and during Bernanke's Aug. 2 meeting with Freddie Mac Chairman Richard Syron, the schedule shows.

``He is going up and down his staff,'' gathering information on markets, Thomas said, referring to Bernanke.

The chairman continued to get reports on market conditions from investors after cutting the discount rate.

On Aug. 23, the schedule says Bernanke took a call from John Brennan, 53, chief executive officer of Vanguard Group. Senior Fed economists Brian Madigan, now in charge of the Monetary Affairs Division, and Patrick Parkinson, a financial stability expert, participated.

Vanguard managed $1.1 trillion in mutual fund assets at the end of 2006, according to the company's Web site.

The Housing Market Is In Full Retreat

Excerpts below from an article from Market Watch indicates, that the pending home sales index hit an all time low in August. One can no longer describe the conditions in the housing market as “beat goes on”, it is now in fall retreat. Home owners still will not drop the prices on their homes, which basically means that the market is bound to crash some more. The original press release can be found at NAR.

The pending home sales index fell 6.5% in August after dropping a revised 10.7% in July, the National Association of Realtors reported Tuesday. The index is at its lowest level since its inception in 2001.

Pending home sales are down by 21.5% compared with a year ago and by 22% compared with six months ago.

"This is still absolutely awful, confirming that the existing-homes market is now in freefall," (my emphasis) wrote Ian Shepherdson, chief U.S. economist for High Frequency Economics. "This is consistent with existing-home sales falling to just 5 million or so," down 10% from the latest level and 30% from the peak.

Sellers still do not realize they must cut prices, said Joel Naroff, president of Naroff Economic Advisers. (my emphasis)

"Fewer contracts were being written because of mortgage availability issues," said Lawrence Yun, senior economist for the Realtors group.

In August, financing for mortgages dried up and dozens of mortgage providers went under as hedge funds, banks and other investors re-evaluated their portfolios of mortgage-backed securities.

"The volume of activity we're seeing today is below sustainable market fundamentals because some creditworthy people are trying to buy homes but can't because of the credit crunch," Yun noted.

I do not agree with comments of Mr. Yun. I talk to mortgage brokers quite often and if you think you are going to buy a home with a credit score of 620 with 3% down, you are wrong. Credit worthy now is defined as anything that can be sold to Fannie Mae or Freddie Mac, the FHA or VA, all of which have strict underwriting criteria. The problem that we have is that potential borrowers either are not in good enough shape to qualify for a mortgage or they are going to the wrong institution. The applicant has poor credit, inadequate income, insufficient downpayment, etc. or they are not shopping enough for good mortgages. Try the regional or nation wide banks, they are doing a lot of fixed rate, full-term, prime lending that can be sold into the well established secondary market or on rarer occassion they are holding some mortgages in portfolio.

The trade group said an informal survey of Realtors showed 10% of sales contracts in August fell through at the last minute because of canceled mortgage commitments. In some areas, 30% of contracts fell through. Sounds to me like too many people are still going to brokers for exotic mortgages. THOSE DAYS ARE GONE.

The index for pending home sales is based on signed sales contracts for existing homes. The transaction is reported as a sale when it closes, usually a month or two after the sales contract is signed.

Pending sales for August dropped in all four regions. Pending sales fell by 9.5% in the South, by 8.3% in the Northeast, by 2.9% in the Midwest and by 2.7% in the West.

Through August, total sales of new and existing homes were down 14% compared with a year earlier and 26% from the peak in mid-2005.

Two Weeks After the Fed Rate Cut and All Is Not Well in the Credit Markets

Two weeks after the Fed cut the Fed Funds rate, liqudity has not been restored to the credit markets like many thought (although I am not sure why). The only people that have benefitted from the rate cut are those in the stock market. However, there even seems to be a problem in this area. The stock increases of late are not broad based and the volumes are not that high, suggesting that the stock market increases of the last few weeks are somewhat anemic. (Portions in bold are my emphasis and not in the original article.) From Bloomberg:

As far as the world's biggest bond investors are concerned, the Federal Reserve is failing to restore confidence in the U.S. credit markets.

Pacific Investment Management Co., TIAA-CREF and Insight Investment Management say the central bank's decision to lower the overnight lending rate between banks by half a percentage point last month won't prevent the economy from slowing or corporate defaults from increasing. Lehman Brothers Holdings Inc. strategists say last month's rally in high-yield corporate bonds, the biggest since 2003, may fizzle by year-end.

While indexes of derivatives that measure the risk of default show increasing investor confidence, the difference between the interest that banks and the U.S. government pay for three-month loans is wider now than a month ago. That's a sign the Fed's Sept. 18 rate decision has yet to persuade bondholders that lower borrowing costs will stop ``disruptions in financial markets'' from hurting the economy.

``The reality is the fundamentals haven't gotten any better, and, if anything, they've gotten worse,'' said Mark Kiesel, an executive vice president at Newport Beach, California-based Pimco who oversees $85 billion in corporate bonds.

About three-quarters of 30 fund managers who oversee $1.25 trillion expect a hedge fund or credit market blowup in the ``near future,'' according to a survey by Jersey City, New Jersey-based research firm Ried, Thunberg & Co. dated Oct. 1.

Former Treasury Secretary Lawrence Summers said Sept. 27 that there is an almost even chance the economy will fall into its first recession in six years. New York-based Goldman Sachs Group Inc., the world's most profitable securities firm, reduced its estimate of economic growth in 2008 last week by about a third, to 1.8 percent from 2.6 percent, because of fallout from the worst housing slump in at least 16 years.

``I'm still bearish,'' said Alex Moss, a senior credit analyst at Insight, a London-based money manager with $94 billion of fixed-income assets. ``I can't see any real excuse to get involved in this market.''

More than 3 percent of company bonds were distressed in September, triple the amount in July, Standard & Poor's said in a report last week. Bonds are considered distressed when they yield at least 10 percentage points more than comparable- maturity Treasuries. Moody's Investors Service forecasts the U.S. default rate will more than double to 4 percent in the next year. New York-based S&P and Moody's are the largest credit- rating companies.

``The big picture is you're going to have a consumer that is going to be pulling back significantly,'' Pimco's Kiesel said. ``The rate cuts by the Fed are unlikely to save housing.'' The Fed's Sept. 18 reduction of its target federal funds rate to 4.75 percent was ``intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets.''

The difference between the dollar London interbank offered rate, which banks use to lend to each other, and the three-month Treasury bill yield shows . . . . that (The) so-called TED- spread has climbed to 1.33 percentage points from 1 percentage point on Aug. 27.

The North American CDX investment-grade index rose 5.75 basis points last week to 55.5 basis points, the biggest increase in more than a month, according to Deutsche Bank AG prices.

While banks working for New York-based Kohlberg Kravis Roberts & Co. sold $9.4 billion of loans to finance the leveraged buyout of First Data Corp. in Greenwood Village, Colorado, lenders still need to find investors for more than $300 billion of loans and bonds to fund pending takeovers.

Morgan Stanley, Lehman and Bear Stearns Cos. in New York reported lower third-quarter profits last month after writing down the values of unsold loans and losses on securities linked to subprime mortgages for people with patchy credit histories.

This rally will be ``pretty short-lived,'' said Richard Cheng, who co-manages $45 billion in investment-grade corporate bonds at TIAA-CREF in New York. ``The economy might be slowing down and third quarter earnings releases may be a little bit difficult. We see spreads widening a little bit more.''

Sales of collateralized debt obligations, the biggest buyers of corporate loans in the first half, fell 54 percent in August to $17 billion from July, the lowest in more than a year, according to Morgan Stanley. CDOs are created by packaging bonds, loans or credit-default swaps and using their income to pay investors interest.

The reduction in collateralized loan obligations may make it more difficult to sell the debt, according to Dan Fuss, vice chairman of Boston-based Loomis Sayles & Co. CLOs bought as much as 60 percent of loans for LBOs this year, according to New York-based JPMorgan Chase & Co. analysts.

``The impact of the CLO freeze up is certainly not out yet,'' said Fuss, who oversees $22 billion of bonds.

More than 65 percent of investors in mortgage-backed securities are struggling to find bids for their holdings, according to a survey of 251 institutions last month by Greenwich Associates, a Greenwich, Connecticut-based consulting firm. Among holders of CDOs, the figure is 80 percent.

The U.S. commercial paper market is shrinking. The amount of debt outstanding that matures in 270 days or less fell $13.6 billion the week ended Sept. 26 to a seasonally adjusted $1.86 trillion, according to the Fed. It's down 17 percent in the past seven weeks.

``People said this subprime liquidity issue was going to go away after Labor Day,'' said Tom Quindlen, CEO of corporate lending at GE Commercial Finance in Norwalk, Connecticut, a unit of General Electric Co. that has $14 billion of assets.

``The bankers were going to return from vacation and just jump right back in,'' said Quindlen. ``That's what I heard in August. Well, they get back from vacation and they're saying it's the first half of 2008. I think it's going to be longer rather than shorter.''

The Current Economic Environment Is Nothing Like the Past - We Are In Uncharted Territory

In trying to understand what is happening in the financial world today, many in the market spend their time comparing the current situation to something that happened in the recent past (I call it fighting the last war syndrome). As a result everyone is comparing the current market to the Long Term Capital Management (LTCM) of 1998. The situation today is different from the LTCM situation a decade ago. However, using the LTCM history as a model for today’s market is a serious mistake as the article below illustrates. By the way, the article below is written by Stephen King, the managing director of economics at HSBC and is published in The Independent. I mention this because I find the scenario below to be fairly scary. (Also anything in bold or in color is my emphasis and not in the original article.)

Earlier in the year, economic life seemed so straightforward. Growth around the world was buoyant. Inflationary pressures were building. Excess liquidity – however defined – was a major worry. The vast majority of central banks were planning on raising interest rates.
Over the past few weeks, though, this consensus has completely broken down. Investors don't know what to think. Should they still be worried about inflation? Or, instead, should they fret about a sub-prime-induced recession? Should they regard the Federal Reserve's recent interest-rate cuts as temporary aberrations, with rates likely to rise again next year? Or are we on the verge of a sustained period of interest-rate reductions in the US, the UK and elsewhere?

It's not just investors who have these worries. Policymakers, too, are feeling distinctly uneasy, realising they're the victims of events seemingly beyond their control. To be fair to the world's central bankers, they'd been warning for some time about the perils of excessive leverage and the dangers of unnecessary risk-taking. And perhaps there were too many deaf ears around.

The problem now, though, is not so much the abandonment of the old consensus but, rather, the adjustment to a new one. The sub-prime shock has thrown so many issues up in the air that no one, yet, knows quite how they will eventually fall to the ground.

For the time being, people content themselves with stories. They reassure themselves that what will happen now will, in some ways, mimic tales from the past. And, for optimists, the obvious stories to turn to are those which had happy endings (perhaps they were fed on a diet of fairy-tales when they were younger).

Many investors are attracted to the 1998 financial crisis associated with the collapse of Long Term Capital Management, the hedge fund whose managers made bets in Asia and Russia which ultimately went horribly wrong. At the time, the big bad wolf of financial and economic collapse appeared to be lurking just around the corner, but the fear was far worse than the reality. A knight in shining armour turned up – to be precise, Alan Greenspan – to save the day through a series of interest-rate cuts. Despite warnings to the contrary, the end wasn't nigh and, shortly after the LTCM collapse, the developed world embarked on a dot.com fuelled economic boom.
Maybe we're again going through an LTCM moment. But why focus on that episode alone?

While there are similarities – a financial crisis, a couple of US interest rate cuts, a firm response from equity markets – there are also plenty of differences. LTCM was a one-off event, an isolated incident that threatened to bring down the financial system but ultimately failed to do so. The latest round of difficulties seems more complicated. We've already had bank failures in Germany, the UK and, with NetBank's demise on Friday, in the US. This, therefore, is a period of sustained uncertainty, with elephant traps cropping up all over the place. Trust – or lack of it – has become a major issue.

When LTCM struck, the US economy was in a relatively healthy state. Today, US economic fundamentals look a lot more worrying. The housing market has been in dire straits for a couple of years now, yet we have still to see the full force of the downswing. Only recently have house prices started to decline. As credit conditions are tightened in the months ahead, there's a good chance that prices will fall even further. And this story is unlikely to be confined to the US alone. Housing markets also look vulnerable here in the UK, as well as in Spain, Ireland and, possibly, France.

Perhaps the biggest difference, though, between 1998's LTCM crisis and the latest set of problems is the inflationary backdrop. During the 12 months leading up to LTCM's autumn collapse, the Asian crisis and Russian debt default had given rise to major disinflationary trends in the industrialised world. The dollar was strong, as more and more investors fled emerging markets in a flight to US quality. Simultaneously, commodity prices were in a state of collapse, reflecting the economic implosions taking place in the emerging world. Back then, cutting interest rates was relatively easy.

The economic landscape today couldn't be more different. With oil prices at around $80 per barrel and with food prices rising swiftly, the global inflationary picture is nothing like as benign. This contrast reflects the improved fortunes of many emerging markets. Wherever you look – China, India, Russia, the Middle East and many parts of Latin America – growth has proved surprisingly resilient in the face of heightened caution in the US and elsewhere. Many emerging economies are on the fast track to prosperity – and that, in turn, means lots of demand for energy and food.

Moreover, many of these countries are partially dependent on the Federal Reserve for their monetary policies, courtesy of currency regimes which, to a greater or lesser degree, are tied to the dollar (in much the same way that the UK's economic policies were tied to those of Germany's Bundesbank</