Daily Insight

U.S. stocks swung between gain and loss 22 times yesterday -- but at least didn’t tank in the final hour, ala Tuesday -- as Congress engages in its typical game playing. At times it seemed Paulson and Bernanke were getting through to them, other times it did not. The concern right now though is not really that the plan won’t be approved but that it will become less effective than the originally clean version as everything from executive compensation to offering additional assistance to those that bought more house than they could afford gets added in.


The market has moved to a wait and see mode and Congress better understand that the plan known as TARP needs be finalized by Monday or the reality of the situation will deliver the message in a harsh way. Warren Buffet made a huge bet yesterday (even if the terms of his investment in Goldman Sachs were supreme) that this plan will be implemented soon and one can guarantee he’ll be on the phone explaining the need for speed.

TARP’s original intent was to unclog the credit markets so the situation doesn’t lead to deep and broad implications for the overall economy that will affect even those that manage their lives in a responsible way, not to simply bail out poor decision making – as much of what the majority is attempting to push into this plan seems to think this is about. But this is Congress and it will likely take this give and take to get the deal through. That’s unfortunate because there is a risk to participation in the plan as a result and thus the pricing mechanism for these troubles assets may not work as efficiently.

This entire situation has been exacerbated by accounting standards that make zero sense, but we must first deal with the seized up credit markets and then we can get the accounting back to something that has a glimmer of common sense to it. We’ll also have to finally learn the perils of reckless monetary policy and the flawed Keynesian models that heretofore have driven the Fed’s decision making.

Market Activity for September 24 2008
Credit markets tightened further yesterday as spreads widened to the alarming levels we saw last Thursday that sparked a fire under everyone to implement a strategy that removes troubled assets from the system – the government has the luxury of buying and holding these assets so that something close to a hold-to-maturity value is realized; the banking system does not at this point. Banks continue to bolster balance sheets on concern the TARP proposal won’t happen quickly enough – speed is of the essence; it seems members of Congress have finally realized this.

The charts below show the extent to which the credit markets have tightened.

The first chart, the TED spread, measures the risk-averse nature of the market. A wider spread means the market is running for safety.

The second chart shows one-month LIBOR – LIBOR is the rate that banks in London can borrow from each other. (Important to note, some LIBOR rates are used to set adjustable rate mortgage rates here in the U.S.).

Bottom line, when these indicators shoot up it means the credit markets are not flowing freely – and at these levels that’s an understatement.



The one-week T-bill now yields 12 basis points (or 0.12%), which shows as clearly as anything that cash has run for cover. Return doesn’t matter, so long as you get your dollar back.

Despite the serious nature of this credit-market lock up, stocks have held up very well, and so long as one is properly diversified you can mange the downside. Again, if Congress is going to play around with this, the market will send them a message that will get their attention.

We discussed the TARP (Troubled Asset Relief Program) hearings enough yesterday, but I want to just touch on a comment made by one of the Congressman on Wednesday. He said he has received 200 calls opposing the bailout. (This is not a bailout, this a an attempt to stop a freeze up of the credit markets from reverberating throughout the economy and touching every citizen as a result) He went on to state: if he gathered with his constituents to say the rescue was needed to increase the availability of auto loans, they’d laugh him out of that town-hall meeting.

One could actually feel compassion for a person like this if his ignorance were not so harmful. Um, this is not about making sure some reckless consumer has the credit available to buy that 5 series Bimmer. This is about keeping commercial, mortgage, consumer, and short-term business credit going. If the credit markets are not unclogged, it is not only some foolish consumers desiring to buy something he can’t afford that will be affected. We are talking about stock market savings and home prices. The declines we have seen in these two savings vehicles (the largest savings vehicles) is child’s play if this intervention is not accomplished, which is why it will eventually pass. I’m not trying to alarm anyone, just stating the facts as this letter has always tried to do.

What we have seen late yesterday and into last night is encouraging as it appears things are starting to roll along – I think Congress believed they could drag this process into next week; they are understanding now that that would not be a good choice. The executive compensation limits that Congress is demanding to be added will find compromise and is doable. It doesn’t involve dollar amounts, but removes the “golden parachute ” – common ground is assured on this one. But then there is what’s known as “Cramdown” that some are trying to push into the plan. This grants bankruptcy judges the power to determine interest rates on mortgage loans that are in workout. This is a no go, a terribly bad choice and will not be added in the end.

Back to the normal business of the day

On the economic front, existing home sales fell 2.2% in August to an annual pace of 4.91 million from 5.02 million in July. Home resales were down 10.7% compared to the year ago period.


The median price of an existing home fell 3.4% in August and is down 9.4% over the past 12 months. This is a necessary condition to get sales rolling again. The concern is that the frozen credit markets – and holding up TARP – will cause the availability of credit to decline and cause prices to fall in a disorderly manner.

We’re not talking about those with sketchy credit -- more stringent credit standards should be viewed as a long-term positive coming out of a period with which there were no standards – but considering the way credit is jammed up right now there is the possibility even creditworthy borrowers may have problems getting a loan.


By region, the August home price declines occurred in the Northeast and West regions -- down 6.6% and 5.3%, respectively. Prices actually rose slightly in the South and Midwest -- up 0.5% and 0.9%, respectively.

The supply of exiting homes (this figure measures the number of months it would take to deplete supply at the current sales pace) did ease a bit, but nevertheless remains disturbingly elevated.

The number of existing homes for sale (a different figure that is just a straight number and not relative to the rate of sales) fell 7% in August – falling from 4.57 million units to 4.25 million units. So long as this number continues to decline, or even flattens out, the months’ worth of supply figure can drop quickly once sales ramp up . This will not occur though until the credit markets flow free. Even then, it won’t occur overnight, but will take quite a while still.

This housing data was mostly ignored by the market yesterday as all focus was on Bernanke and Paulson, but I thought it was important to mention.

This morning we get August durable goods orders, initial jobless claims and new home sales.

Have a great day!

Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks declined on concern Congress will hold up a facility to house and patiently sell off troubled mortgage assets, marking the worst two-day slump in six years – this is the message the market will continue to send, and that message may get louder because if the credit markets remain frozen the cost to the economy will be much greater than the $750 billion that everyone is fixated on.

Commodity stocks led the decline as investors worry a sustained credit freeze will reverberate throughout the global economy. Basic material shares declined 3.19% and oil stocks slipped 2.86%. Not far behind were industrial shares, down 2.51%. Health-care shares were the relative winners, down just 0.45%.

Market Activity for September 23 2008
Back to this distressed-credit facility, Bernanke and Paulson were on the Hill yesterday attempting to persuade Congress that this plan – now known as the Troubled Asset Relief Program (TARP), I can see the play on words already from those of whom oppose this idea – needs to get done, but they received the cold shoulder from members of the Senate who have suddenly found reason to protect the taxpayer.

This is laughable to me. These are the same people that seemed all to eager to advance a $170 billion rebate check scheme disguised as a “stimulus” package, which delivered no help whatsoever outside of a two month pop in consumer spending. Members of Congress have also talked about another “stimulus” package that would supposedly cost another $150 billion. So right there you’re looking at $320 billion. And I won’t even get into a welfare system that these individuals hold dear -- a tragedy that costs trillions and has destroyed inner city families, communities and schools. But we are supposed to believe that these people are now the protector of the taxpayer.

Again, everyone seems fixated on this $750 billion figure. What? Are all of these troubled loans worthless? Serious delinquent subprime mortgage loans now total 18%. Assume the number rises to 30% -- heck the government is going to buy these assets at a discount anyway (somewhere between distressed prices and a held-to-maturity value, at least based on the plan that has been proposed).

Personally, I doubt they’ll lose much money at all over the several years they take to sell off these loans. But assume they lose half. Ok, that’s $375 billion, or 2.5% of GDP. In my view, the cost to the economy will be far far greater than that if the credit markets remain frozen -- current accounting rules result in a write-down loop that has banks suddenly unwilling to lend as they hoard cash for fear their capital adequacy ratios will fall.

The major downside is the longer this gets dragged out the more it presents an opportunity for politicians to stuff this plan with all kinds of social projects that have nothing to do with freeing up the credit markets and in fact create impediments to the capital markets

Enough of that for now, there is some good news this morning as Warren Buffet is taking a $5 billion stake in Goldman Sachs via perpetual preferred shares that carry a 10% dividend yield. The deal includes warrants that give him the right to buy another $5 billion worth of stock with a strike price of $115 per share – exercisable any time for five years (the stock currently trades at $130).

It is being reported that Buffet really likes Goldman. Who wouldn’t with these terms? This is something the average investor could only dream off. In any event, it has juiced stock-index futures so it may provide some relief after a two-day beating.

In other news, House Democrats have conceded defeat and will allow the offshore drilling ban to expire – the majority had been blocking even a vote on the issue, but constituents have beat them into submission as gasoline prices remain elevated. Now it goes to the Senate; passage would be huge for energy prices over time and significant from a geopolitical standpoint as it will send a message we have finally begun to get serious.

On the economic front, the Office of Federal Housing Enterprise Oversight (OFHEO) released their latest index on home prices, which showed a 0.6% decline in July. Home prices have slipped 5.4% over the past 12 months, according to this measure.
The hardest hit areas were the Pacific (down 1.0% in July), New England (down 1.0%) and Mid-Atlantic (down 1.1%) regions. Interestingly, the South Atlantic (largely Florida) – one of the hardest hit areas -- has seen prices behave quite well over the past two months. That region saw prices fall just 0.4% in July, which followed a 0.2% increase in June. The Mountain region is also looking pretty good as the larger price declines that have taken place over the last couple of years may have run course – too early to tell, but the trend is looking much better.

Overall, this look at housing is the most broad of all the indicators and is why we believe it gives a more accurate picture than does the S&P Case/Shiller Home Price Index, which has prices down 16% year-over-year (this is the index that gets the headlines). Case/Shiller covers the 20 largest metro areas, half of which have been the hardest hit. While the OFHEO index has its flaws – it fails to capture the higher-end housing market – it does offer a much more diversified look.

Bottom line, when you factor in both of these reports along with the new and existing home sales data, it offers a pretty good feel of what has occurred nationally. Weight all of these indexes equally and prices have declined roughly 8.5% from a national perspective over the past year.

In a separate report, the Richmond Fed Index (manufacturing activity) showed the east coast market continues to see weak factory orders persist as the September reading came in at minus 18. This is quite different from the Chicago region (the largest manufacturing base) and ISM survey (the broadest look) which remains pretty upbeat considering all that is going on.

There was nothing in the Richmond survey to provide any hope over the short term. As most of you know, we focus on the sub-indices within these surveys to offer some insight on how the sector will behave over the next six months. In the case of Richmond, the shipments, new orders and back log indices all posted ugly readings. Even the prices paid index, which has declined a bit among the other factory surveys, remained elevated – actually increased a bit from the August reading.

The charts below show how depressed manufacturing activity is in the Richmond Federal Reserve district compared to the national view. (Remember though, zero marks the line of demarcation between expansion/contraction for the Richmond survey and 50 is the line of demarcation for ISM).




Correction:

Yesterday I stated the following when touching on monetary policy mistakes:
Why did they leave fed funds so low for so long? Simply because the unemployment rate remained below where Greenspan and Co. wanted it. That’s the reason. They ignored that this Phillips Curve mentality has proven feckless, and at times harmful, for 30 years now and continued instead to grasp it no matter how precarious the hold.

I meant to say because the unemployment rate remained above where Greenspan & Co wanted it.

The overall point was that the Fed ignored the reality the economy was booming and inflation was running at a rate that vastly exceeded their fed funds target – real fed funds was negative. This subsidizing of debt encouraged the financial sector to increase leverage and a large percentage of home buyers to move to adjustable rate mortgages – two factors that have caused the current situation to become quite unpleasant.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks erased Friday’s gains as worries mounted that internal conflict will delay a plan to deal with troubled financial assets and thus keep the credit markets frozen. So the S&P 500 is back to where it ended on Thursday, 4.5% above the September 17 multi-year low yet 22.6% below the all-time high hit nearly one year ago.

Of course, financial shares led the indices lower, plunging 8.48% yesterday. Consumer discretionary, industrial and information technology shares also shed 3% or more – all 10 major industry groups closed down on the day.

Monday’s stock-market activity sends the message not to play around with this thing, get it done – cut and dry. It is imperative to get this facility up and going and to completely dismiss some of the Congressional proposals that are delaying the process. We’ll soon find out if Congress is listening.

Market Activity for September 22 2008
And speaking of the government plan, we’ve heard a lot about the financial system and what ails it over the past few days – and a good thing too as the credit markets completely froze up last week. But almost universal among the many proposals to fix this thing is a refusal to lay any blame for who is responsible for this mess, so long as the particular pundit’s solutions are implemented. Well, let’s be clear, we better lay some blame because without it we fail to concentrate on what got us here and thus will not learn from the mistake. So let’s discuss the primary mistakes.

There are two things that brought us to this dead end – and I mean that as credit markets had failed to work of late and the write-down game becomes a never-ending loop; it is Federal Reserve policy and mark-to-market accounting. (Yes, there are many other things that have exacerbated the issue, but these two are the main problems as the former is the root cause, the latter providing the coup de grace).

The FOMC believed – as it still does – they could manage the economy using their flawed Keynesian models and as a result left their benchmark interest rate at 1.25% even as nominal economic growth average 6.5% -- 3.2% in real terms – in the 12 months ending June 2004; that’s running on all cylinders. (In fact, the Fed left fed funds at 2.00% or below for three full years.)

Why did they leave fed funds so low for so long? Simply because the unemployment rate remained below where Greenspan and Co. wanted it. That’s the reason. They ignored that this Phillips Curve mentality has proven feckless, and at times harmful, for 30 years now and continued to grasp it no matter how precarious the hold.

It was the low interest rate environment that encouraged all of the worst things we now know about the credit/housing market situation. We must not allow this to occur again.

The next thing we should learn is not to fall for so-called “sophisticated” models used to price assets – especially for the financial sector where these assets have 10-20 year lives. We were told these models were much more dynamic than the commons sense ways of the past, which used an original cost framework on which the financial sector based capital adequacy ratios.

These new models were developed largely during a period in which asset prices almost only went up -- never tested against what we now face.

Beyond that though the idea never made much sense from the get go. Mark, or price, assets that have 10-20 year lives to a market that is distressed? Not smart.

When asset prices fall firms must raise capital – lest that capital falls below the required level --, they then must sell off more assets to do so, which sends prices even lower, or at least the models that are used to price these assets. The process snowballs and becomes a never-ending loop until a firm is driven out of business. If we only returned to the rules these assets were accounted for just a few years ago, I’m convinced capital adequacy would have never have become a problem and asset prices would reflect a value that is actually close to intrinsic value – right now that is not the case and why an RTC-like facility to house and eventually sell off these assets will not be a losing proposition. (Sure thing, those firms that were leveraged to the hilt would still be in a world of hurt, but I’m talking about the industry as a whole. If we had mark-to-market based accounting during the S&L crisis one only knows how bad things would have become).

So while we listen to all of the solutions – some quite good and some very bad – let us not forget that a recklessly easy Fed and moronic accounting rules are the preponderate mistakes that have led us down this road.

The dollar is getting hit on news that it will take roughly $750 billion to create this facility to house and then sell off troubled assets in an orderly way. This dollar move is both logical and expected based on that number, but without a change in the accounting rules, I’m not sure there is another choice. (Under the Treasury Department’s original intent these assets will be bought at a substantial discount and will come out ahead on the deal – ie. No taxpayer harm, so long as the Congress doesn’t screw the thing up).

Concerns that the cleaner proposal presented on Friday may become saddled with New Deal-type programs likely caused more dollar harm than would otherwise have been the case.


The October contract for crude soared yesterday, jumping $16.37 per barrel, or 15.7%. That contract expired yesterday and it’s pretty obvious the jump was due to the classic short squeeze. Those that remained short had to cover those positions or be force with actually delivering the oil. The November contract rose at only half that amount. You’ll see oil open around $107 per barrel this morning. That’s not because oil has suddenly plunged $13 but because the November contract only rose to $108 yesterday. The two charts below illustrate this point.



We were without an economic release yesterday but get back to it today with the Richmond Fed Index and OFHEO’s Home Price Index. Data on both new and existing home sales, durable goods orders and the final revision to GDP will round out the week.

Thanks to Peter for doing a great job while I was out yesterday.

Have a great day!


Brent Vondera, Senior Analyst

Daily Insight

Capping off a historic week, stocks rallied sharply for the second-straight day as drastic moves by the government were announced to bail out the banks. Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke announced the removal of illiquid mortgage securities from companies’ balance sheets while the SEC temporarily banned the short sale of 799 financial services companies. As a result, financials led the rally gaining 11.13 percent on Friday.

Market Activity for September 19, 2008
If you were on vacation last week, you might think nothing interesting happened since stocks ended relatively flat for the week. However, the Dow posted triple-digit moves every session in response to a variety of events such as Lehman Brothers filing for Chapter 11 bankruptcy protection, Merrill Lynch and Bank of America’s shotgun wedding, the Fed leaving its target fed funds rate unchanged, the government taking over the world’s largest insurer AIG, two money market funds “broke the buck,” and yields on three-month Treasury Bills rose a few basis points above zero.

On Saturday morning, a three-page bill was delivered to members of Congress asking them to give Paulson unchecked power to buy $700 billion in bad mortgage investment from financial companies in what would be an unprecedented government intrusion into the markets.

The plan would raise the ceiling on the national debt and spend as much as the combined annual budgets of the Departments of Defense, Education, and Health and Human Services. Paulson was asking for the power to hire asset managers and award contracts to private companies. Most provisions would expire after two years from the date of enactment.

On Sunday, the Fed agreed to convert investment banks Morgan Stanley and Goldman Sachs into traditional bank holding companies, thus subjecting the firms to greater regulation and likely lower profitability. (It has become somewhat of a Sunday ritual for me to see what big announcement the government will make on Sundays.)

Goldman and Morgan Stanley have maneuvered through the credit crisis better than other investment banks, but the Fed feared the investment-banking model could not function in these markets for much longer. Investment banks depend on short-term money markets to fund themselves, but that has become increasingly difficult, particularly in the wake of the collapse of Lehman Brothers. As bank holding companies, Morgan Stanley and Goldman Sachs will be allowed to take customer deposits, which are potentially a more stable source of funding.

With the attention focused squarely on the financial crisis and government efforts to unclog the credit markets, the economic calendar will probably take a back seat on Wall Street again this week.

Wednesday we will get the report on existing home sales, which account for about 85 percent of the total home sales and have been at the root of the financial crisis that shook the markets last week. Sales in August are forecast to decline 1.2 percent to an annual rate of 4.94 million units, suggesting that the housing market will get no relief from the uncomfortably high inventory levels and declining home prices.

It is still too early to tell how homebuyers will be affected by the recently-passed housing bill, the bailout of the nation’s largest mortgage buyers Fannie Mae and Feddie Mac, and the monumental developments in the financial markets, but it is crucial for homebuyer confidence to begin to be restored for the economy to gain traction.

Other reports that will be released include durable goods orders, new home sales, and weekly initial jobless claims on Thursday. And, of course, the final 2Q GDP will cap off the week.\

Brent will be back tomorrow and I’m sure he will have plenty to say about these historic events.


Have a great day!


Peter Lazaroff, Junior Analyst