Daily Insight

U.S. stocks ended essentially flat on Friday as we received conflicting economic reports, people waited to see what effect Hurricane Ike would have on energy infrastructure and traders waited to see how the Lehman story would play out over the weekend. (We now know we are seeing a fundamental ship in the financial system, one that will be painful in the short-term, but helpful longer-term as the most fit institutions survive.)

Energy, basic material and utility shares were the sectors that gained ground Friday. The other seven major industry groups closed lower led by financial shares, which declined 1.06%.

Market Activity for September 12 2008
I won’t expand on what occurred in Friday’s trading session as we must move to things more important – the developments over the weekend.

We’ll divide this morning’s letter into two parts. First, we’ll discuss the events of the weekend and I’ll do my best to sum it up – so much occurred. This will be followed by commentary on Friday’s economic data – if anyone cares to read on after getting through the developments of the past two days.

We went into the weekend with the Treasury Department and Federal Reserve helping to negotiate a deal for Lehman Brothers to be purchased. Their real estate assets had eroded to the point they couldn’t use them as collateral for the PDCF (one of the Fed’s newer discount window facilities that allowed broker-dealers to borrow from the Fed) and it was either find a buyer or file for bankruptcy – as you may all know by now the latter occurred.

And as a result, there was a big game of chicken being played. Bids were due at 5:00ET Saturday, but nothing was accomplished, as BAC and Barclays demanded the government backstop the deal in order for them to take on Lehman’s troubled assets. (One had to wonder also if the buyer would get downgraded as a result of taking on these assets.)

At the same time the Fed and Treasury stood by their statement that they would not assist financially, so you had a stare down. This is what the Bear Stearns deal has brought us – even if it were necessary prior to PDCF (Primary Dealer Credit Facility) being set up.

Treasury and Federal Reserve Approach

The government was attempting to set up a “bad” bank – as they were terming it – that would contain $85 billion of Lehman’s poor-performing real-estate assets and many of the major financial institutions would be tasked to provide capital to this “bad” bank. This will help to unwind these trades in an orderly fashion. They tried something similar earlier this year, but it received the cold shoulder then as well. It appears we’re going to get something like that in the end, but it didn’t help with getting a Lehman deal done.

Digressing a bit and just to touch on trading – it appears we’ve got a rolling short on our hands as hedge funds, speculators, whomever, bring one financial firm down only to move onto the next.

Just look at AIG for instance. AIG will have to raise additional capital if downgraded, which seems quite likely. But this shouldn’t be a problem as they have several healthy businesses that are marketable and can raise huge sums of cash – their aircraft leasing business to name one. AIG has also gone to the Fed for a bridge loan until one or several units can be sold.

Yesterday, Sunday, banks and brokerage firms began preparing for a Lehman bankruptcy filing after BofA and Barclays pulled out of the Lehman talks.

Purpose of the exercise was to reduce risk associated with bankruptcy by netting, or matching, derivatives contracts involving Lehman.

The good news – no government assistance -- is that this will force the market to adapt to the new environment and indeed much of this is underway. At least for now, the potential players in future transactions will not assume government financial assistance. But this will involve short-term pain, and a very difficult trading session today for sure – that’s how it works.

Unfortunately, this mess will lead to re-regulation. We hear how the decision to deregulate the industry is the reason for the financial-sector turmoil – please. This deregulation led to much lower commissions and meant lower transaction costs for the individual investor. The problem was the Fed kept rates way too low for too long and it encouraged a massive amount of leverage to take place as institutions borrowed at very low short-term rates to invest in longer-term securities. This helped them to offset the lower commissions from deregulation. In the end, this will be viewed as a monetary policy mistake.

OK, now back to the weekend developments. Within all that was going on something unexpected occurred, Bank of America and Merrill Lynch apparently found reason to talk and $29 per share is the official number as they will buy Merrill. (This is a stock deal and since BofA shares are down roughly 12% the deal is closer to $24 per share, or a 40% premium over Friday’s closing price.) BAC is either making some very smart long-run decisions or some really dumb ones (remember they bought Countrywide too). One wonders what BAC sees in Merrill’s balance sheet to offer a premium like that. That at least could be very good news that is overlooked right now.

In another development, the Fed will accept an even wider range of collateral now, including equities, in order to facilitate the leverage wind down.

The Federal Reserve continues to increase the risk to their balance sheet. This will likely have an adverse effect on the dollar. (To that balance sheet issue though, at these markdowns the Fed should be ok.)

It terms of this rolling short situation, the Bank America/Merrill deal should help to contain this trade. This is likely why Merrill was committed to selling itself this weekend. Those that went into the weekend with short positions on Merrill will get clobbered this morning and will cause others to think twice.

Morgan Stanley and Goldman Sachs are now the only independent broker dealers left – the model is in a state of catastrophe and they may look to sell too.

This all, like so many things over the past several years, is hugely historic.

Stock-index futures are down big this morning, but as of the current indication the Dow will open about 3.0% lower and roughly 4% on the S&P 500. If we close at those levels, I’d call it a moral victory.

Oil Prices

These developments have completely offset the impact on oil prices from Hurricane Ike. Even though the storm took out 10 platforms in the Gulf and a large percentage of refineries will be down for some time, oil is off by 4.5% this morning to $96.80 per barrel. This is a combination of global growth concerns and hedge funds, among others, forced to sell to raise cash.

We’ve often talked about how business and consumer loan growth has remained pretty healthy even as credit standards have tightened over the past year. It will be very interesting to see how the market reacts here as the availability of credit will almost surely contract due to the financial sector tightening its belt. But this is part of the adaption away from reckless behavior and into a situation that mirrors common sense and is actually sustainable.

On the economic front Friday, the Labor Department reported that the producer price index (PPI) fell 0.9% in August as a large decline in the energy component helped this month-over-month figure ease.

Yet, core PPI (ex-food and energy) rose 0.2% in August and over the past 12 months this figure rose 3.6% -- an acceleration from the previous reading. Overall PPI (including everything) is up 9.6% year-over-year (YOY), a slight deceleration from last month’s reading of 9.8%. Bottom line, producer prices remain sticky even with the large drop in energy prices. Maybe the energy price trend begins to show up in the next reading, but hasn’t occurred just yet.


A component we’ve been watching to get a feel of whether inflation has become embedded is the core intermediate goods number. This involves the materials used to produce the finished good and excludes energy. The reading was up 1.7% in August, 21.7% three-month annualized and 12.5% YOY – that YOY reading actually accelerated from 10.2% in the July reading.


In a separate report, the Commerce Department reported that business inventories rose 1.1% in July – we still obviously have August and September data to get through – but this will help Q3 GDP if the trend continues – and sales rose as well, up 0.5%. I was expecting business sales to decline after rising 18% on a three-month annualized basis, but this is good news as the production needed to rebuild inventories will help economic growth offset the weak areas. One can be pretty sure though that we’ll see business sales contract when the September figure is released simply based on how hot they’ve been.

Sales are up 8.8% year-over-year and five-straight months of increase helps to illustrate that there are at least some areas of the economy that continue to perform quite well.




Lastly, Commerce reported that retail sales fell 0.3% in August, as the figure was pressured by gasoline station receipts and building material sales. Gasoline station receipts fell a large 2.5% last month on the combination of lower prices and reduced demand. Building material sales fell 2.2% -- this component has been soft for a while (for obvious reasons) – but this is a big drop.

What’s known as core retail sales – which excludes gasoline, building materials and autos (you may be asking if there is anything left) – declined 0.2%. This is the figure that flows directly into the GDP report regarding the personal consumption component and shows that the consumer will probably be of little help within Q3 GDP.

We’ll note that auto sales rose a strong 1.9% as automakers offered incentives that seemed to do the trick. This may have subtracted from other areas of the data. In any event, the overall report was weak

We’ve talked about this possibility (meaningful consumer weakness) for a couple of weeks now, as the labor market is weak and real income growth has been flat due to rising prices. On the bright side, capital expenditures data does indicate the business side of things will help to offset this weakness. As touched on above, the low inventory environment should keep production on an upward trend, which will also help. This will all depend on how the financial-sector woes play out, which is not looking good for the immediate term.

Have a great day!

Brent Vondera, Senior Analyst