Daily Insight

U.S. stocks jumped yesterday supposedly on news the government is formulating a “permanent” (run for cover when you hear that one) plan to shore up financial markets. The actual reason stocks reversed course and rallied mid-session on a day that the mood was unpleasant and the credit markets remained frozen is anyone’s guess. One gets a sense it was not this “permanent” plan, at least the Senator Schumer version which was nothing more than re-enacting the New Deal. Lord help us!

This version of the plan was not to set up an RTC-type facility to house troubled paper then to sell in an orderly way, but instead to inject government funds in exchange for equity stakes in financial companies and re-writing mortgages to make them more affordable. We can all discuss whether the efforts heretofore are helpful or not, but fat chance with this New Deal-type plan occurring – the housing/credit market is in a tough state, but I don’t think we’re ready to become socialists just yet.

Certainly helping financial shares rebound, which led the advance as the sector gained 11.73%, was the crackdown on a form of short selling that was suppose to be illegal in the first place but apparently not enforced until now.

Industrial and information technology shares were among the next-best performers, up 3.57% and 3.98%, respectively.

Market Activity for September 18 2008

Monetary authorities also played a role as central banks around the world – US, EU, Japan, Canada and Swiss announced coordinated measures to ad massive amounts of liquidity to the banking system. The Fed doubled its existing currency swap with the ECB and Swiss Bank. In addition, they authorized new facilities with the Bank of England, Japan and Canada.

Bottom line, this measure is aimed at reducing funding pressures in the interbank market and to lower LIBOR rates.

Outside of other major issues, many adjustable rate mortgages run off of LIBOR rates, which has jumped big time over the past couple of days as banks are unwilling to lend to their peers. Overnight LIBOR fell to 3.84% from 5.03% but three month LIBOR actually rose – nice try though. Risk aversion remained extremely elevated – as evidence by the three-month Treasury bill that yields just 8 basis points -- and in my humble opinion I don’t see how the Fed’s action changes this. (No, that is not a typo on the three-month T-bill yield, it really is 0.08% -- investors are paying for the safety and liquidity of the Treasury market.)

On the economic front, initial jobless claims for the week ended September 13 rose 10,000 to 455,000. The Labor Department reported claims were boosted because of the impact of Hurricane Gustav. Claims have been elevated for eight weeks now, but I was comforted to see the figure remain below 475,000 in light of Gulf coast weather. Of course, we’ll see the effect of Ike over the next couple of weeks as Houston was hit hard by this storm.

Continuing claims fell 55,000, which is nice, although you won’t hear it reported. I’m not saying we should get excited about this move lower, but it certainly doesn’t hurt.

The current level of claims does not bode well for the September job report, but I don’t think there was anyone on the planet expecting anything special anyway. While this level of jobless claims is unwelcome, it remains well-below the prior two peaks and continues to suggest monthly job losses will remain in the 60,000-80,000 range and not the 150,000-plus level that we see in the typical period of labor market weakness.


In a separate report, the Philly Fed index – a measure of manufacturing activity in the Philadelphia Fed Bank region – came in much higher than expected, rising to post a positive reading of 3.8, the estimate was for a negative 10. (To offer some clarity to new readers, a reading above zero marks expansion, as opposed to the ISM and Chicago-area manufacturing survey in which a number above 50 marks expansion.)

A couple of the underlying sub-indices within the overall survey improved nicely as new orders jumped to 5.6 from -11.9 in August and shipments posted 2.6 from -3.3 last month. If not for a large drag from the inventory component the total survey would have been stronger. That inventory index came in at -22.9 vs. -6.6 in the previous reading as stockpiles plunged, but this is good for next month’s reading as production will likely kick up to replace inventories.

Lastly, household net worth fell 3.5% in the second quarter, as reported by the Federal Reserve via their flow of funds report. Clearly, falling home and stock prices pushed the figure lower – although, as the chart below illustrates it remains elevated (up 48% since 2002 and 212% over the past 20 years).


I’ll note, household liabilities as a share of net worth rose to a record 25.9%, which is up from 18% in 2001. This corresponds with the easy money policy of the Fed – specifically the duration of that easing campaign even as the economy began to boom in 2003 and was in an all out sprint by 2004.

Have a great weekend!

Brent Vondera, Senior Analyst

Acropolis in the News

Chris Lissner appeared in Jerri Stroud's most recent article in the St. Louis Post-Dispatch.

Click here or on the logo to read the article.

Daily Insight

U.S. stocks tumbled, mirroring Monday’s move, as the credit markets remain largely frozen. Problem is banks continue to hoard cash, as we’ve talked about for a couple of days now, and this causes the whole system to seize up -- we’ll touch on this issue more specifically below.

To no one’s surprise on a day of substantial decline, financial shares took the brunt of the beating – losing 8.94%. Although, the losses were widespread as utilities fell 5.33%, information technology down 4.9%, consumer discretionary shares fell 4.84% and industrial shares lost 4.77%.

On financial shares, we must put an end to what short sellers are doing here. I normally wouldn’t favor such action, but there are times when the authorities have to step up and take Machiavellian action (swift, effective and short-lived). This is one of those times.

The SEC has decided to actually – hopefully this time it’s for real – prosecute those engaging naked short trades (shorting stocks without having the shares to deliver). This will help. They must also reinstate the uptick rule, meaning one must wait for the stock price to tick up before selling short. This rule was eliminated on July 6, 2007. The SEC ran a one-year pilot program, eliminating the rule back in 2004 and all went well, which encouraged them to reverse the rule. However, this is not 2004 and it’s pretty obvious a rolling short is in play -- short one financial stock to zero and move onto the next.

Market Activity for September 17, 2008
For sure, it is the reckless behavior of financial institutions, encouraged by the Fed’s very terrible mistake of keeping rates too low for too long all the way into 2005 (fed funds was kept at 2.00% or below for three full years) even as the economy began to boom in 2003 and was hitting on almost all cylinders by 2004. This reckless behavior by the financial sector is ultimately why the short-trade even got rolling. But we can’t change that now. The raid must be stopped.

In addition, consumers -- specifically many home buyers -- were reckless as well, which is why we’re dealing with this “toxic” paper that no one wants to touch and firms are stuck in a continual write-down loop as a result.

There are people talking about creating a new RTC (Resolution Trust Corporation, which was set up to liquidate assets in an orderly way due to the S&L crisis 20 years ago) to buy up the “bad” paper – sub-prime, Alt-A mortgages etc. – and selling them off in a orderly way. This may be a good idea.

I’d bet a new RTC would eventually make large sums of money off of this because it seems very likely, to me, these assets that continue to be written down are worth much more than currently marked to. And that’s one of the problems.

The mark-to-market accounting seems deeply harmful in my view. Why in the world mark these assets to where they can be sold in a distressed market? In fact, that’s putting it mildly. There is no market for this paper, but the collateral behind it is worth much more than currently assessed. For heaven’s sake, the mortgage market looks ugly, but we’re talking about 93% of mortgage payments are on time. The write-down scenario would make one think this number to be more like 60%. The authorities will eventually get a clue and switch to net present value accounting these instruments that have 10-20 year lives.

That to me is the answer, the accounting standard change.

We’re seeing the farce of the supposedly sophisticated models used to value assets in this mark-to-market accounting rule. As financial firms try to sell distressed assets it lowers the price even more, which makes them even harder to sell – buyers will not step in until they perceive a bottom has been reached. As asset prices fall its causes banks, among others, to raise capital. It becomes self-feeding. And this is why financial institutions are hoarding cash and credit markets are frozen.

The accounting rules must be changed – as former Fed governor Larry Lindsey stated so well yesterday in the WSJ editorial page; I encourage anyone with a WSJ subscription to read it. We must either move to more stable capital adequacy rules – basing capital ratios on original asset values or net present value these longer-term assets. This will put a halt to the capital concern and unfreeze the credit markets. You can’t do this overnight, but changing the rule to take place over the next year will help immensely. As some smart guy from the past said (the name escapes me) the best time to plant a tree is 20 years ago; the next best time is now.

We see this morning that central banks around the world are coordinating to pump $247 billion into the system. This is one of the things central banks are tasked to due and it may help. Then again, it may be like squeezing Silly Putty -- squeeze all you want there will be other areas that stick out. The accounting rules must be changed; this is the ultimate solution for now, in my view.

There are people saying the Fed needs to lower rates – these types think just because the FOMC hasn’t pushed rates lower since March that rates are not low enough. Look, it is not appropriate to view the fed funds rate by itself, but against current levels of inflation (averaging the three major inflation gauges). By this measure, you’re looking at a negative fed funds rate of -3.00%; this is a hugely accommodative stance.

On the Bright Side

The events of late have presented an enormous multi-year stock-market opportunity, but things may very well remain jittery for several months and I am not at all calling a bottom here. Just pointing out that once we get beyond this the attractive nature of the major indices will allow for above normal returns.

The S&P 500 trades at an earnings yield of 7% based on the earnings forecast for the next four quarters, while the 10-year Treasury yields a whopping 3.38% -- even relative to the past 12 months worth of earnings, the S&P 500’s earnings yield remains 101 basis points above the 10-year rate.

The chart below illustrates this point. The series that offers a historic view of the S&P 500 earnings yield was discontinued in October 2007, but the calculation is simply the inverse of the p/e ratio so we can plot where it is today – as represented by the point on the right side of the chart. This presents the largest spread in favor of stocks in at least 30 years. The index also carries the highest dividend yield in 12 years. (Other indices also show favorable ratios as the Dow trades at 13 times earnings and carries a dividend yield of 3.07% and the NYSE Composite – which includes higher growth medium and small cap stocks -- currently trades at 15 times earnings and a 3.40% dividend yield.)

Unfortunately, there are some real disturbances, if I can call it that, in the credit markets, so patience is certainly needed in this environment. And possibly some areas may need to be avoided in the very short term if the credit markets do not improve over the next few days.

On the economic front, the National Association of Home Builders broke ground on fewer homes than forecast in August. Housing starts fell 6.2% to 895,000 at an annual rate.

Multi-family starts plunged 15.1%, while single-family starts fell 1.9% last month.


Also, building permits, a sign of future construction, dropped 8.9% to an 854,000 annual pace. Both of these figures remain at the lowest pace since 1991.


This illustrates the residential housing component of GDP will continue to weigh on economic growth. We were under no illusion that housing would magically begin to support growth again, but figures over the past couple of months did at least begin to show the level of decline had eased – in fact the latest GDP report showed this occur in the second quarter. But the past couple months of data are a pretty clear sign that residential fixed investment will subtract another full percentage point from real economic growth – marking the 10th straight quarter of drag.

Certainly, the degree of decline among multi-family units overstates the underlying weakness in housing; it nevertheless suggests that residential investment is going to be a large drag on third-quarter growth.

Based on the data we have at this point, we still expect the Q3 GDP number to come in better than most expect. The business side of the economy will offset some of the weakness consumer activity will show and export growth may more than offset the housing drag. However, this is based on the assumption export growth remains strong. I think it will for the current quarter, but it seems apparent this segment will slow next quarter based on the slowdown the European economy is now enduring. At that point, if housing doesn’t show a little life, the fourth-quarter GDP reading will likely be flat. One hopes the rise in homebuilder optimism is a sign the degree to which housing activity is declining wanes over the next few months.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks were all over the map yesterday, moving 2.0% to the downside at its lowest point – while the market waited for the FOMC decision and more importantly how authorities would deal with AIG – but rallied hard in the final 90 minutes of trading on word the Fed would provide a loan to AIG and the FOMC held pat as the inflation gauges barely moved even with oil’s large move lower.

The S&P 500 moved between gain and loss at least 10 times yesterday, and the chart below paints the picture as investors weighed the fate of the largest insurer and the cascading effects that would results from an AIG bankruptcy. What occurred in the credit markets yesterday was hugely concerning.

We’ve heard people say credit markets had seized up and for a year now, but this letter has provided evidence that this had not occurred – at least not in a broad sense. Well, over the past two trading sessions it occurred as the credit markets were very much frozen and it definitely had an effect on the Fed’s and Treasury’s decision to take action regarding AIG.


Market Activity for September 16 2008
Financial and energy shares led the indices higher, but the gains were widespread as all but two of the major industry groups gained ground.

On AIG, the Federal Reserve decided to provide an $85 billion loan and in return the Treasury Department will receive warrants representing the right to a 79.9% stake in AIG. AIG would commit to sell a basket of assets (its several business units both insurance and non-insurance) within a certain time frame. The loan has duration of 24 months at a rate of three-month LIBOR plus 850 basis points. That equals 11.25% and one would think guarantees AIG will not play around with getting these businesses sold. This should not adversely affect the taxpayer – outside of unintended consequences that we cannot grasp at this point – as the government will very likely make money off of this action.

In other market news, the $62 billion Primary Fund of the Reserve (a New York money-market firm) broke the buck (NAV went below $1) due to investments in bonds issued by Lehman. It’s been 14 years since a money-market fund has fell below $1 – one has to go back to the Orange County bankruptcy in 1994. This underlines the reckless risk that has been undertaken for amazingly little boost in return.

AIG is Lehman on steroids and it seems a collapse needed to be avoided. The firm was a major seller of credit-default swaps (insurance default on assets tied to corporate and mortgage securities). Bankruptcy would force financial institutions globally to take huge write-downs as a result.

Let’s hope this month marks the bottom in this chaotic situation, but one can’t say so with confidence. One thing is for sure with this whole mess, risk is getting re-priced and it will be a long time before risk management become as reckless as it became over the past several years. Each company and manager is responsible for their own actions, but personally I lay the ultimate blame at the feet of the FOMC.

Gasoline Prices

Wholesale gasoline prices continued to plunge, falling another 4.74% to $2.44 per gallon yesterday, even as the combo of Hurricanes Gustav and Ike have forced 6.3 million barrels a day of refining capacity to shut down in Louisiana and Texas. Gasoline supplies are at their lowest point in eight years, according to the Energy Department.

At some point prices will reflect this situation, or maybe prices are simply returning to levels prior to the Fed’s abrupt easing campaign that caused hedge funds to flow into the energy trade as a way to guard against inflation. I’m skeptical energy prices will remain at these levels considering heightened geopolitical concerns, which have been ignored with all that is going on in the credit markets.

Further, the energy bill working its way through Congress is a sham. It continues to lock up 85% of the outer continental shelf (OTC), restricts oil-shale production and does not offer royalties to states that lie along 15% of the OTC that is available for production. One big joke.


On the economic front, the Labor Department reported that the consumer price index eased in August, but not by much even as the energy component fell substantially. Food prices rose 0.6% in August and accelerated to 6.1% year-over-year (YOY) from 6.0% in July.

For the overall index, (including everything) CPI declined 0.1% in August and decelerated on a YOY basis to 5.4% from 5.6% in July.


The core rate, which excludes both food and energy – a measure the Fed watches closely – remained unchanged at 2.5% on a year-over-year basis.


The Cleveland Federal Reserve Bank’s Mean CPI – this measure takes a weighted mean of the CPI and gives one the sense what inflation is doing outside of wild swings in certain components – remained unchanged at 3.3%.

What does all of this tell us? It shows that inflation remains sticky and is counter to the Fed’s prediction that overall price activity would come lower along with the decline in energy. (This is where their Keynesian models lead them in the wrong direction)

And speaking of the Fed, the FOMC (the group that determines monetary policy) made the correct decision (in my view) yesterday by keeping their fed funds target rate unchanged at 2.00%. Monetary policy needs to be devoted to price stability – and as just mentioned – their assumption that inflation would come lower simply because energy price have plunged has failed to come to fruition. The members of the FOMC have been mugged by reality and this obviously drove their decision yesterday.

Further, jacking rates lower is what got us into this mess in the first place – keeping rates too low for too long subsidized debt, encouraged financial institutions to abandon risk management and created a commodity spike. The Fed has many other tools with which to provide liquidity and it is about time they held the line on fed funds even as the Street was demanding a cut – fed funds futures had the probability of a cut at 80% prior to the announcement.

The central bank added liquidity through their open market operations yesterday morning. This was needed to get the effective fed funds rate to a level that is closer to their target –although it remained above their desired mark for most of the day as banks hoard cash in this uncertain environment.

Also, the Fed auctioned $20 billion in 28-day repos for mortgage-backed securities as an additional way to increase liquidity into the system. (This is part of the TSLF – or Term Securities Lending Facility in which they broadened the types of collateral, in this case mortgage-backed paper, for its 19 primary dealers for a set period. This temporarily raising the amount of money available in the banking system. At the end of this 28-day period they return the securities to the dealers, and they cash to the Fed.)

In the statement that accompanies the rate decision, the FOMC stated they will continue to address market turmoil with emergency lending (noting, “[s]trains in financial markets have increased significantly”) and the prior easing actions should promote moderate economic growth over time. Their statement, “the inflation outlook remains uncertain” clearly illustrates the latest inflation gauges played a major role in deciding to hold their fed funds target unchanged.

The current economic weakness is not due to lack of demand for goods and services, but because of poor risk management. It is a good thing the Fed held the line.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks took their expected beating yesterday, pushing the S&P 500 1.8% below the July 15 mark – thus making a new multi-year low; a two-year low to be exact. By mid-day it appeared the market wanted to hold above that level – 10,962 on the Dow -- but it was not so as half of the day’s damage was done in the final 90 minutes of trading.

The Dow Industrial Average lost 504 points Monday, just four points shy of the October 19, 1987 crash. The difference is that in percentage terms the decline meant 22.6% was shaved from the index back in 1987; today such a drop amounts to 4.4% -- although you wouldn’t know it by the way its getting reporting.

Market Activity for September 15 2008

Financial shares got clocked, falling 10.4%, largely driven by AIG shares, but BAC also pushed the financial index lower due to the Merrill purchase premium. Worries over AIG pressured the market all day as questions rose over their ability to raise capital; however, after the market close the company received approval to access $20 billion of capital in its subsidiaries to free up liquidity to buy time for that capital raise. Now they have other issues due to ratings downgrades that were issued late last night – this is the news of the day and we’ll touch on the topic a bit more in a moment.

All 10 major industry groups were hit hard yesterday, but along with the financial group energy was the other major decliner, losing 6.87% as oil prices fell 5.41% to $95.71 per barrel.

This morning crude is down further, off another 2.85% to the $92 handle. I guess people are thinking these companies will have trouble making money at $90 per barrel, or they fear crude will move to $70. If so, energy-company profits will still post strong results and in the meantime it effectively removes a major burden from the consumer. I’ve even heard people state that the drop in energy will help those that bought more house than they could afford pay their mortgage now. That obviously is taking things too far.

But back to AIG, the ratings agencies downgraded AIG last night which may trigger another $13 billion in collateral calls. AIG needs capital and they need it now as they also were sucked into the leverage trap, big time. The Treasury and Federal Reserve were in discussions last night – bringing JP Morgan and Goldman Sachs in to round up these funds.

The authorities must not be that worried about it though, since they have not chosen to tear down the regulations that keeps mountains of private equity out of the available capital pool. To my understanding current regulations state that anything larger than a 25% stake in an insurance company means the private equity firm is now treated like a bank; regulated like a bank. You can forget capital to the rescue from this group so long as this is the case. According to reports though, without this regulatory hurdle private-equity capital wants in.

Credit Markets Increasingly Jittery

The rush to find, or keep capital was evident by the action in the effective fed funds rate, which jumped to 6.00% at one point yesterday until the Federal Reserve engaged in operations to bring the rate lower -- this is the rate at which private banks lend balances to other depository institutions overnight. As you all may know this is also the rate the Federal Reserve targets to set their monetary policy agenda. But that is just a target, as the chart below illustrates, the effective fed funds rate had jumped as there is both a scrambling for liquidity and an occupying (unwillingness to let it go) of liquidity for those that currently have excess. The target fed funds rate stands at 2.00%.

The TED spread also shows the state of risk aversion yesterday as the index jumped – not unlike during other events during this period of credit-market chaos. For new readers, this is the spread between three-month Treasury bills and LIBOR. Bottom line, when the spread widens it indicates investors’ and institutions’ increased desire for safe investments. When it narrows it illustrates a willingness to take on more risk as default risk, or the perception of which, decreases

The Press

I don’t want to make light of what is occurring, this is serious stuff – as the above graphs help to illustrate, but the way the financial press, along with the rest of the media, is playing this thing has gotten way out of hand. The concern is that it drives people to think their bank accounts are not safe.

What the media is doing right now even stuns me. Terms like “horror” on Wall Street and these developments “shake individuals to their core” were used yesterday and last night.

Horror? Shaking individuals to their core? Only if these ignorant media participants tip off a panic will people be shaken to their core. Heck, CNBC is running a “special” each night – all night – entitled “Is Your Money Safe?” Beyond the headline of this “special” the mood and alarm exhibited by these people is astounding. One must realize though that they are receiving the best ratings in their history; then you understand the alarmism, which of course causes more people to tune in.

Capital

We’ll also point out something else that is hugely important right now, and gets zero attention. The economy, the system as a whole, is stuffed with capital. There is no shortage of it, but there is an unwillingness to use it in the current environment, or large amounts are being blocked out by regulation as we touched on above.

Let’s run through some numbers. Huge amounts of capital has been created and re-built over the past few years.

The New York Stock Exchange Composite has seen its market cap grow more than $7 trillion over the past few years – even with the latest 20% decline on the index.

Another $900 billion has been created via after-tax corporate profits since 2001. And this figure is adjusted for inventories and capital consumption so there’s no chicanery in this number. (It’s tough to read but the graph shows an increase of $888 billion.

Another $1.2 trillion has been added in real disposable income – that’s inflation adjusted. This is not all counted as capital, as most of this money gets spent, but we know that a decent percentage has been added to the markets and is likely available on the sideline right now.

In fact, money market accounts currently stand at $3.1 trillion – as of the latest data – which is enough to buy 27% of the S&P 500.

Point of all of this is things could be much worse. At some point the smog of uncertainty and worry clears. In time, the housing market will stabilize – household creation and demographics will make it so on its own – at which point the write-downs will cease. (What isn’t helping things in this regard, and is actually exacerbating the situation, are rather dumb accounting rules in my view that make firms mark assets to market when in fact there is no market for much of this stuff. Why mark to where it can be sold in a distressed market? Better to net present value this stuff that have 10-20 year lives)

And this is what investors should be thinking about. No, it is not a time to be a hero, the market is in a tenuous state, but this is when longer-run opportunities present themselves for those who can look past this all – it’s tough though, I know.

I’ve bifurcated the letter again, feeling the need to touch on the current state of things and we’ve gotten long. Read on if you care about yesterday’s economic data.

On the economic front, the New York Fed reported that manufacturing activity (as measured by the Empire Manufacturing index) contracted in September after bouncing to back to expansion in August. The index slipped to negative 7.41 from positive 2.77.

Still, there were some positives as the prices paid index came down big time, new orders accelerated and shipments were positive.

This rise in new orders shows the Empire’s decline in August was not a marked deterioration. Further, the index for business conditions six month out jumped to 43.11 from 34.58 in August.

Also, keep in mind that nation-wide manufacturing activity remains right at the point that separates expansion from contraction – point is it is holding up remarkably well during this period if economic weakness and credit-market troubles. The New York area has been hit hard by the credit troubles, which helps explain why factory activity in the Northeast region looks worse than for the country as a whole.

In a separate report, the Commerce Department reported industrial production fell a large 1.1% after two months of increase. The drivers were a 11.9% plunge in auto production and a 3.2% decline in utility usage – due to extremely mild weather. These two segments account for 15% of total industrial production.

Overall, every segment declined in August, save information processing. It was a pretty miserable report, but the large decline was vastly due to the auto and utility realities. Auto inventories have been trimmed substantially and this segment should provide a boost for the current month. (Auto sales remain weak from a historical perspective, but we did see sales bounce in August as automakers’ incentives were successful.)

This morning we get the Consumer Price Index for August and the FOMC (Federal Open Market Committee – the group that sets monetary policy) meeting, which should be interesting. Odds are the FOMC will cut fed funds down to 1.75%. The minority view is that they’ll leave it at 2.00% and use other ways to inject liquidity.


Have a great day!


Brent Vondera, Senior Analyst

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