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July 26, 2008

A GSE Perspective
by Doug Noland

Hyper-volatility was the order of the week, although the major averages ended with only small changes. For the week, the Dow declined 1.1% (down 14.3% y-t-d) and the S&P500 slipped 0.2% (down 14.3%). The Morgan Stanley Cyclicals dipped 0.4% (down 15.9%), while the Morgan Stanley Consumer index mustered a 0.1% gain (down 9.8%). The Transports declined 0.9% (up 8.5%), and the Utilities were smacked for 2.4% (down 11.4%). The broader market fared better. The small cap Russell 2000 jumped 2.5%, lowering 2008 losses to 7.3%. The S&P400 Mid-Caps slipped only 0.6%, also down 7.3% y-t-d. The NASDAQ100 gained 1.3% (down 11.4%), and the Morgan Stanley High Tech index declined 0.6% (down 11.5%). The Semiconductors were hammered for 7.7% (down 11.5%). The Street.com Internet Index added 0.6%, and the NASDAQ Telecommunications index surged 6.8% (down 6.4%). The Biotechs jumped 4.8%, increasing 2008 gains to 6.0%. The Broker/Dealers fell 6.0% (down 30.3%), while the Banks recovered 0.7% (down 28.7%). With Bullion sinking $25, the HUI gold index dropped 6.4% (down 0.1%).

One-month Treasury bill rates jumped 44 bps this week to 1.73%, and 3-month yields rose 20 bps to 1.72%. Two-year government yields gained 6 bps to 2.70%. Five-year T-note yields increased 3 bps to 3.44%, and 10-year yields added 2 bps to 4.10%. Long-bond yields increased 3 bps to 4.69%. The 2yr/10yr spread narrowed 5 to 140 bps. The implied yield on 3-month December '09 Eurodollars declined 2 bps to 4.105%. Benchmark Fannie MBS yields fell back 7 bps to 6.08%. The spread between benchmark MBS and 10-year Treasuries narrowed 8 to a still quite wide 198. The spread on Fannie's 5% 2017 note narrowed 10 bps to 63 bps, and the spread on Freddie's 5% 2017 note narrowed 10 bps to 64 bps. The 10-year dollar swap spread declined 6.5 to 69.5. Corporate bond spreads were mostly narrower. An index of investment grade bond spreads narrowed 5 to 140 bps, and an index of junk bond spreads narrowed 10 to 548 bps.

It was another light week of corporate debt issuance. Investment grade issuance this week included Dupont $2.0bn and IBM $1.0bn.

Junk issuers included XM Satellite $780 million.

Convert issuers this week included Alliance Data $700 million.

International dollar bond issuance included Taqa Abu Dhabi $1.5bn, Severstal $1.25bn, GAZ Capital $500 million, and Alpha Bank $250 million.

German 10-year bund yields rose 3 bps to 4.60%. The German DAX equities index recovered 0.8% (down 20.2% y-t-d). Japanese 10-year "JGB" yields added one basis point to 1.57%. The Nikkei 225 jumped 3.5% (down 12.9% y-t-d and 25.3% y-o-y). Emerging markets were volatile and ended the week mixed. Brazil's benchmark dollar bond yields declined 5 bps to 5.91%. Brazil's Bovespa equities index sank 4.6% (down 10.5% y-t-d). The Mexican Bolsa fell 3.9% (down 8.3% y-t-d). Mexico's 10-year $ yields rose 6.5 bps to 5.58%. Russia's RTS equities index sank 8.6% (down 14.8% y-t-d). India's Sensex equities index rallied 4.7%, cutting y-t-d losses to 29.6%. China's Shanghai Exchange index gained 3.1%, lowering 2008 losses to 45.5%.

Freddie Mac 30-year fixed mortgage rates surged an extraordinary 37 bps to an 11-month high 6.63% (down 6bps y-o-y). Fifteen-year fixed rates jumped 40 bps to 6.18% (down 19bps y-o-y), and one-year adjustable rates rose 39 bps to 5.49% (down 20 bps y-o-y).

Bank Credit jumped $25.6bn to $9.418 TN (week of 7/16). Bank Credit has expanded $205bn y-t-d, or 4.0% annualized. Bank Credit posted a 52-week rise of $775bn, or 9.0%. For the week, Securities Credit added $1.4bn. Loans & Leases jumped $24.2bn to $6.911 TN (52-wk gain of $586bn, or 9.3%). C&I loans gained $4.4bn, with one-year growth of 18.3%. Real Estate loans slipped $0.4bn (up 1% y-t-d). Consumer loans increased $5.8bn, and Securities loans rose $7.3bn. Other loans gained $7.0bn.

M2 (narrow) "money" supply was little changed at $7.698 TN (week of 7/14). Narrow "money" has expanded $236bn y-t-d, or 5.9% annualized, with a y-o-y rise of $428bn, or 5.9%. For the week, Currency declined $0.7bn, and Demand & Checkable Deposits fell $9.4bn. Savings Deposits increased $8.3bn, and Small Denominated Deposits added $0.8bn. Retail Money Funds increased $1.2bn.

Total Money Market Fund assets (from Invest Co Inst) rose $8.8bn to $3.507 TN, with a y-t-d increase of $394bn, or 22.7% annualized. Money Fund assets have posted a one-year increase of $924bn (35.7%).

Asset-Backed Securities (ABS) issuance remained steady at a slow $2.5bn. Year-to-date total US ABS issuance of $114bn (tallied by JPMorgan's Christopher Flanagan) is running at 27% of comparable 2007. Home Equity ABS issuance of $303 million compares with 2007's $207bn. Year-to-date CDO issuance of $14.7bn compares to the year ago $249bn.

Total Commercial Paper outstanding declined $5.8bn this week to $1.744 TN, with a y-t-d decline of $41.3bn. Asset-backed CP rose $4.7bn last week to $750bn, reducing 2008's decline to $22.8bn. Over the past year, total CP has contracted $481bn, or 21.6%, with ABCP down $440bn, or 36.9%.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 7/23) increased $5.5bn to a record $2.353 TN. "Custody holdings" were up $297bn y-t-d, or 25% annualized, and $350bn year-over-year (17.5%). Federal Reserve Credit declined $5.4bn to $883bn. Fed Credit has expanded $9.5bn y-t-d (1.9% annualized) and $32.8bn y-o-y (3.9%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.384 TN y-o-y, or 26.5%, to a record $6.987 TN.

July 24 - Bloomberg (Maria Levitov): "Russia's international reserves, the world's third largest, rose to a record $588.3 billion last week, the central bank said. The value of the reserves increased by $10 billion in the week..."

Global Credit Market Dislocation Watch:

July 21 - Bloomberg (Caroline Salas): "A third of U.S. fixed-income investors are unwinding bad bets, according to a Greenwich Associates Survey. 'The market's biggest traders are still dumping problem securities, not buying,' Tim Sangston, a consultant at... Greenwich Associates, wrote... Among money managers who trade more than $50 billion of fixed-income securities annually, 47% said they plan to unwind positions. Of the investors who said they need to sell securities, about 30% aim to dump asset-backed securities and/or investment-grade bonds and a quarter would like to sell mortgage- backed securities... A third of investors are also looking to capitalize on the market turmoil by buying illiquid securities... More than half of the investors polled said they have altered or plan to change their strategies because of the credit market rout, and of those, 60% will invest in higher-quality securities, the survey said."

July 21 - Wall Street Journal (Justin Lahart): "With the credit crunch on Wall Street entering its second year, a widening array of businesses are finding it tough to get credit. And with mortgage giants Fannie Mae and Freddie Mac roiling credit markets, individuals could soon find it harder to get a loan as well... Banks also are pulling back on the amount of rainy-day money they have been giving out to corporate clients in the form of loans called revolving-credit facilities... Overall, the value of credit held by banks in the second quarter shrank 1.5% from the first quarter, according to Federal Reserve data. That was the largest three-month contraction since 1948. These tight credit conditions are particularly worrisome because the Federal Reserve has responded aggressively since the credit crunch emerged last July... Credit is the lifeblood of economic activity. If it continues to be hard to get... that could spell trouble for an economy teetering on the edge of recession."

July 20 - Reuters (Nick Carey): "As losses mount at American banks and the pain of the credit crisis spreads from housing and finance to the broader economy, many small companies complain it is increasingly difficult to obtain loans. Tighter credit could not only help to push the United States into recession, but prolong the downturn as ideas for new businesses get stymied once entrepreneurs sit down with local bank managers, small business representatives warn. 'In recent weeks we've seen banks becoming more cautious and the pace of lending has slowed considerably,' said Weldon Gibson, a consultant at the Lamar University Small Business Development Center in Texas. 'They are demanding higher credit scores and want more collateral before lending.' Small businesses are a linchpin of the U.S. economy because they form the backbone of the country's jobs market and are crucial for job creation."

July 25 - Bloomberg (Dawn Kopecki and Shannon D. Harrington): "Standard & Poor's may downgrade the subordinated bonds of Fannie Mae and Freddie Mac, surprising investors who had anticipated the securities would be supported by any Treasury rescue plan. The potential cut would affect $19.2 billion of AA- rated subordinated debt at Fannie Mae and Freddie Mac..."

July 23 - Financial Times (Anousha Sakoui): " A year ago today, US-owned power company Intergen sold $1.875bn of junk bonds - it turned out to be the last high-yield deal to be sold in the young but seemingly flourishing European market. No other deal has been seen since the credit crunch took hold - a worse issuance record over that time in Europe than for risky leveraged loans or even mortgage-backed bonds. Globally, issuance of junk-rated debt has struggled but there have been some deals. The first half of this year saw $43bn of junk bonds sold compared with $121bn in the same period in 2007, according to Citigroup..., a 60% fall. But while many debt markets have continued to struggle since the credit turmoil erupted last summer, the complete hiatus in European high-yield bond markets is increasingly worrying for companies who rely on that market. Billions of euros of such debt are due to mature and be repaid over the next 12 months..."

July 23 - Financial Times (Javier Blas): "SemGroup, the US physical oil trader, yesterday filed for bankruptcy as it acknowledged trading losses of more than $3.2bn in different energy markets after betting this year that crude oil prices would fall. Its collapse came as oil prices plunged to their lowest levels since early June... Oil traders said SemGroup could have exacerbated the spike in oil prices this month, when the market experienced unprecedented swings of more than $10 a barrel, as the company was buying back some previous bets on lower prices. The bankruptcy of SemGroup, which describes itself as the fourteenth largest US private held company, affects approximately $3.1bn of debt, according to court filings... The company said in a court filing that it had lost $2.4bn in oil hedges at the New York Mercantile Exchange and another $850m in over-the-counter energy markets. The credit crunch has exacerbated energy traders' battle with margin calls as banks are reluctant to extend their credit lines."

July 25 - Reuters (Robert Campbell): "The dramatic collapse of energy trader SemGroup LP shocked the privately held firm's backers who until last week had little idea of the extent of the oil trading losses that sank it, sources said this week. As late as June a banker at Bank of America, one of SemGroup's main lenders, described the fast-growing company as one of his best clients, two sources said this week... SemGroup creditors said this week they had little idea of the extent of the firm's losses and were surprised by the much larger than expected size of the hedging program."

July 25 - Bloomberg (Jeremy R. Cooke): "Rates on municipal debt with interest reset weekly jumped the most since February after the top credit ratings of this year's two busiest bond insurers were placed under review by Moody's..."

July 22 - Bloomberg (Fabio Benedetti-Valentini): "Dexia SA, the world's largest lender to local governments, posted a record decline in Brussels trading after Moody's... said the company's U.S. bond- insurance unit may lose its top credit rating... The stock has fallen 50% this year..."

July 21 - Wall Street Journal (Liz Rappaport and Josee Valcourt): "Chrysler LLC is running into heavy new headwinds, this time from its financing arm, Chrysler Financial. The financing arm is likely to see its borrowing costs rise in early August when it rolls over about $30 billion of short-term debt backed by the loans and leases it makes. That, in turn, will make it harder for the company to offer low-interest loans to buyers and for dealers to hold inventory. Bankers, led by J.P. Morgan Chase & Co., are pushing hard to persuade more than 20 banks to renew the $30 billion credit facility -- backed by car loans, leases and loans to dealers -- that was issued by the auto-finance company last year when it was carved out of the former DaimlerChrysler AG."

July 25 - Bloomberg (Mike Ramsey): "Chrysler LLC, the automaker owned by Cerberus Capital Management LP, said it will no longer offer leases to customers through its finance unit. Dealerships can still make leases obtained through independent finance companies..."

July 21 - Bloomberg (Renee Lawrence): "Sears Holdings Corp. and Wal-Mart Stores Inc. are among U.S. retailers that have had to renew their credit facilities with banks on more restrictive terms, the Wall Street Journal reported, without saying where it got the information."

July 22 - Financial Times (Paul J Davies and Jennifer Hughes): "US accounting changes that could force banks to take trillions of dollars back on to their balance sheets will seriously complicate their capital-raising efforts at a time when the money is most needed, standards setters have been warned. More than $10,000bn worth of outstanding bonds backed by mortgages and other consumer and corporate debt could be affected by accounting changes, according to a letter from two leading debt market trade associations to the US Financial Accounting Standards Board... Together with changes to banking regulation that will force banks to hold capital against their off-balance sheet assets, the moves could complicate banks' efforts to get themselves clear of the credit crunch wreckage."

July 22 - Wall Street Journal (Russ Garland): "U.S. venture-capital investing slipped for the second consecutive quarter, suggesting some firms are reluctant to make risky bets as the economy tightens. Venture investors pumped $13.9 billion into 1,241 deals in the first half of this year, figures that are down 5% and 8%, respectively, from a year ago, according to the latest data from VentureSource... This year has been especially painful for venture investors... The National Venture Capital Association earlier this month declared a 'capital market crisis' for the industry."

Global Inflation Turmoil Watch:

July 23 - Financial Times (Barney Jopson in Khartoum and Murithi Mutiga and,Javier Blas): "Hunger on a massive scale is looming across the Horn of Africa as a combination of drought and high food prices have left more than 14m people in five countries in need of emergency food aid, according to the United Nations. Ethiopia is the epicentre of the crisis, with 10.3m people, or 12% of its population, in need of emergency aid in the next few months, the World Food Programme said. But the risk of starvation has spread in an arc that runs from Somalia and Djibouti through to Kenya and Uganda. The primary cause of the crisis is a prolonged drought across large parts of the Horn which has been exacerbated by the soaring costs of food and fuel. The impact is compounded because some countries, such as Ethiopia, have nearly exhausted their food reserves as rising prices forced the governments to subsidise food this year."

July 25 - Financial Times: "East Asia is suffering from a bad case of inflation. That was the diagnosis this week from the Asian Development Bank's Review... The treatment is clear, Asia's governments must make curing inflation the priority. Interest rates across Asia must start to rise. East Asia has aggressively pursued growth for the last decade. When faced with large rises in the price of fuel and foods, governments did not curb demand. Although some Asian central banks have started tightening their monetary policy, it has been too little, too late. Inflation is now at record highs in South Korea and Malaysia. It has broken 25% in Vietnam. Wages are already rising to chase prices."

July 21 - Bloomberg (Jason Folkmanis): "The Vietnamese government's decision to increase retail gasoline prices will probably push consumer inflation past 30%, HSBC... said. Vietnam's year-on-year inflation rate reached 26.8% in June, the highest since at least 1992. The government today announced the price of the most commonly used grade of gasoline in the country has increased by 31%, while the price of kerosene is now 44% higher."

July 24 - Wall Street Journal (Elffie Chew and John Jannarone): "Malaysia and Singapore posted 26-year highs in inflation as food and fuel costs continue to back the region's central banks into a corner. Malaysian inflation rose a higher-than-expected 7.7% year to year in June... 'June CPI data were pretty ugly, and the man in the street is feeling the pain, and if the Malaysian central bank wants an excuse to raise rates, this is it,' said David Cohen, an economist at Action Economics..."

July 22 - Wall Street Journal Asia (Peter Wonacott): "Economic turmoil is roiling Pakistan, spawning another daunting test for the country's wobbly leadership. A key ally of the U.S. in its global fight against al Qaeda and the Taliban, Pakistan already is trying to contain an insurgency by Muslim militants that is spreading from border areas with neighboring Afghanistan. The government also is struggling to hold together a shaky coalition of warring political parties. Now, an onslaught of economic woes threatens to overshadow both these challenges. Runaway food prices, energy shortages and a plunging stock market have hit ordinary Pakistanis hard and left the government scrambling to defuse public anger, say officials and analysts. 'The economic issue is rapidly surpassing all other issues,' says Shahnaz Wazir Ali, a special assistant to Prime Minister Yousuf Raza Gilani..."

July 22 - Bloomberg (Fiona MacDonald): "Kuwaiti lawmaker Mohammed al-Obaid urged the government to take serious measures to curb 'alarming' price rises in food and other commodities, the Arab Times reported. 'The price hike crisis is actually bigger than the security issues or a possible war in the region,' al-Obaid said..."

July 23 - New York Times (Ian Urbina): "Francis McConnell is a field supervisor for the Philadelphia Water Department, but lately he is acting more like an undercover police officer. Several hours a day, five days a week, he stakes out junkyards. Pretending to read a newspaper, Mr. McConnell sits near the entrances and writes down descriptions of passing pickup trucks and shirtless men pushing shopping carts. His mission is to figure out who is stealing the city's manhole covers and its storm drain and street grates, increasingly valuable commodities on the scrap market. More than 2,500 covers and grates have disappeared in the past year, up from an annual average of about 100. Thieves have so thoroughly stripped some neighborhoods on the city's north and southwest sides that some blocks look like slalom courses, dotted with orange cones to warn drivers and pedestrians of gaping holes, some nearly 30 feet deep."

Currency Watch:

The dollar index increased 0.9% to 72.86. For the week on the upside, the Korean won increased 0.8%, the Brazilian real 0.6%, and the Mexican peso 0.3%. On the downside, the New Zealand dollar declined 2.5%, the Australian dollar 2.2%, the Canadian dollar 1.9%, the Swiss franc 1.8%, the Norwegian krone 1.7%, the Swedish krona 1.6%, the Danish krone 1.4%, the Euro 1.4%, and the Japanese yen 1.3%.

Commodities Watch:

July 23 - Financial Times (Chris Flood): "Coal prices have doubled over the past year to record levels and could spike even higher as a power crisis in China combines with supply problems in leading exporting countries to tighten the market further. The surge in prices coincides with fresh interest from hedge funds and other investors looking to gain exposure to the commodity thanks to greater liquidity in the previously opaque over-the-counter coal market... The price gains have come on the back of rising consumption in China, which relies on coal for almost 80% of its electricity generation. Several regions are rationing power supplies as coal shortages become acute. 'The Chinese power crisis is likely to be a major driver of the global coal market over the next few months,' says Francisco Blanch, commodity strategist at Merrill Lynch... The one-year forward contract for the Asian coal benchmark, known as API-4, has risen by almost 124% over the past year..."

Commodities markets are highly unstable. Gold dropped 2.6% to $930 and Silver sank 4.5% to $17.38. August Crude dropped $6.27 to $123.20. August Gasoline was hit for 4.4% (up 22.5% y-t-d), and August Natural Gas sank 14.3% (up 21.1% y-t-d). September Copper declined 1.7%. September Wheat added 0.9%, while August Corn dropped 5.3%. The CRB index was hit for another 3.5% (up 14.9% y-t-d). The Goldman Sachs Commodities Index (GSCI) fell 4.6% (up 24.4% y-t-d and 48.9% y-o-y).

China Watch:

July 21 - Wall Street Journal (Denis McMahon): "After years of cross-border mergers being delayed by authorities wary of foreign companies snapping up Chinese assets too cheaply, Beijing's preoccupation with hot money may be swinging the other way. Some foreign investors are being told by China's currency regulator that they are paying too much for Chinese companies. A surge in inward foreign direct investment this year -- up 46% year-to-year in the first half, compared with a 14% rise for all of 2007 -- suggests potentially volatile speculative funds are flooding into China in the form of high price tags on corporate investments."

July 22 - Bloomberg (Zhang Dingmin): "China's tax revenue rose by 30.5% in the first half as the economy expanded... Tax income rose to 3.3 trillion yuan ($484 billion), the agency said... Revenue from value-added, consumption and business levies climbed 23% to 1.49 trillion yuan..."

July 22 - China Knowledge: "Prices of major agricultural products in China rose 22.9% year-on-year in the first six months of 2008, the National Bureau of Statistics (NBS) of China announced...This was revealed by a nationwide survey of 31,000 agricultural holdings conducted by NBS. During the period, producer prices of plantation products, forestry, animal husbandry and fishing products increased 13.8%, 12.1%, 39.8% and 12.8% respectively."

July 21 - Bloomberg (Nipa Piboontanasawat): "Hong Kong's inflation accelerated in June to the fastest pace in four months as food and energy costs climbed. Consumer prices rose 6.1% from a year earlier... after gaining 5.7% in May."

July 24 - Bloomberg (Nipa Piboontanasawat): "Hong Kong's exports fell for the first time in more than two years in June as shipments to the U.S., Japan and mainland China declined."

Japan Watch:

July 22 - Bloomberg (Toru Fujioka): "Demand for loans among Japanese companies fell to a four-year low as a slowing economy and costlier materials made businesses reluctant to borrow... 'This indicates sluggish growth in business investment, wages and hiring,' said Yasuhide Yajima, a senior economist at NLI Research Institute... 'Companies can't be confident about borrowing money amid the higher costs.'"

July 24 - Bloomberg (Jason Clenfield): "Japan's exports fell for the first time in more than four years as demand for cars and electronics cooled, signaling the U.S. slowdown is spreading to the emerging markets that helped sustain growth. Exports decreased 1.7% in June from a year earlier..."

July 24 - Bloomberg (Bei Hu): "Tokyo overtook London to be the world's second-most expensive city, and living expenses in Indian cities leapt as the dollar weakened and inflation surged, a survey by Mercer LLC said. Moscow was the costliest city for the third year in a row."

Asia Bubble Watch:

July 25 - Financial Times (Raphael Minder): "Asian governments, faced with the highest inflation for a decade or more, are shelving billions of dollars worth of landmark infrastructure projects and shifting funds to more immediate economic assistance. Given the threat presented by surging food and fuel prices, 'the long-term projects go by the wayside in favour of short-term sops to keep people happy', said Edward Teather, an economist at UBS... 'Clearly, inflation now affects everybody.' New governments that took office this year in South Korea, Taiwan and Thailand after campaigning on promises to pump new funds into infrastructure are among those rearranging priorities."

July 23 - Bloomberg (Shamim Adam): "Singapore's inflation unexpectedly held at 7.5% for a third straight month in June..."

Latin America Watch:

July 25 - Bloomberg (Helen Murphy): "Colombia's central bank raised the benchmark interest rate for the second time this year in a bid to combat accelerating consumer prices. Policy makers increased their overnight interbank rate by a quarter-percentage point to a near seven-year high of 10%..."

Unbalanced Global Economy Watch:

July 23 - Bloomberg (Greg Quinn): "Canada's inflation rate in June was the highest since September 2005 as energy cost surged, forcing companies such as Air Canada to raise prices. Consumer prices rose 3.1% from a year earlier..."

July 22 - Financial Times (Chris Flood): "The UK is facing an extended period of weak growth as policymakers battle to control inflation and this week's data releases will confirm that the risk of the economy sinking into recession has risen substantially. With house prices falling at the fastest pace since the 1930s and family budgets under pressure from rising petrol costs, utility bills and food prices, the outlook for consumer spending has clearly deteriorated."

July 24 - Bloomberg (Jennifer Ryan): "U.K. retail sales dropped in June by the most since at least 1986 as accelerating inflation and the slowdown in economic growth prompted consumers to cut spending. Sales fell 3.9% after rising 3.6% in May..."

July 24 - Financial Times (Ralph Atkins): "The eurozone's economic slowdown has worsened markedly according to closely-watched surveys that show growth prospects collapsing across the 15-country bloc. Germany, France and Italy reported sharp falls in business confidence in July, with German business leaders gloomier about the next six months gloomier than for almost six years. Separately, eurozone purchasing managers' indices... showed private-sector economic activity had contracted for the second consecutive month. France's performance deteriorated particularly sharply. 'The downturn is gathering pace faster than expected,' said Chris Williamson, chief economist at Markit..."

July 25 - Financial Times (Ralph Atkins): "Eurozone housing markets have shown fresh signs of cooling, with growth in mortgage lending dropping sharply to the lowest annual rate since the launch of the euro. The latest ECB eurozone lending data... provide fresh evidence of a substantial economic slowdown under way across the 15-country bloc."

July 24 - Bloomberg (Christian Vits): "German business confidence fell the most since the Sept. 11 terrorist attacks in 2001, signaling growth is faltering in Europe's biggest economy."

July 21 - Bloomberg (Joshua Gallu): "Swiss producer and import price inflation accelerated to the fastest pace in almost 19 years in June, a sign that pressure on consumer prices may be building. Prices for factory and farm goods as well as imports rose 4.5% from a year earlier..."

July 24 - Bloomberg (Tasneem Brogger): "Danish consumer confidence dropped in July to the lowest level since November 1992 after declines in property values led the economy into recession and inflation accelerated."

July 22 - Bloomberg (Flavia Krause-Jackson): "Italian consumer confidence slumped in July to the lowest level since the 1993 recession after record food and energy prices eroded purchasing power."

July 23 - Bloomberg (Ben Sills): "Producer prices in Spain accelerated more than economists expected in June to the fastest pace in 23 years as record oil increased costs for manufacturers. The price of goods leaving Spain's factories, farms and mines rose 9% from the year-earlier period..."

July 24 - Dow Jones (Jonathan House and Santiago Perez): "Spanish unemployment rose rapidly in the second quarter as activity in the country's once-buoyant economy slowed sharply at the end of a decade-long construction boom. Data published Thursday by the National Statistics Institute, or INE, showed the country's jobless rate rose to 10.44% in the second quarter from 9.6% in the first quarter."

July 24 - Bloomberg (Tasneem Brogger): "Sweden's unemployment rate rose to a two-year high of 8.1% in June... The... jobless rate rose from 5.9% in May..."

July 22 - Bloomberg (Christos Ziotis): "Greece's budget deficit widened by 54.3% in the first five months of the year as the government increased spending on wages and received less money from taxes on heating oil."

July 23 - Bloomberg (Adam Brown): "Romanian private debt growth, which the central bank says is a main driver of inflation, accelerated in June, driven by increased borrowing in foreign currencies. Private debt grew an annual 63.4% in June..."

July 24 - Dow Jones (Lidia Kelly): "The Russian M2 money supply growth rate expanded to 3.8% on the month in June, after a 2.8% rise in May... On the year, M2 rose 31.2%..."

July 21 - Bloomberg (Alex Nicholson): "Russian producer prices rose in June at the fastest pace since December 2004 as energy and metal prices rose. The cost of goods leaving factories and mines in the world's biggest energy exporter surged 28.1%, compared with 25.1% in May..."

July 23 - Bloomberg (Jacob Greber): "Australian inflation accelerated in the second quarter to the fastest pace in two years... Prices gained 4.5% from a year earlier."

July 23 - Bloomberg (Rebecca Keenan): "The number of Australians who spend more than half their income repaying their mortgage has more than doubled the past year, the Australian Financial Review reported... A quarter of people use more than half their income on repayments, known as 'mortgage stress', compared with 12% a year ago, the newspaper said, citing a survey..."

July 24 - Bloomberg (Tracy Withers): "New Zealand's central bank cut its benchmark interest rate by a quarter point to 8%, the first reduction in five years, saying slowing economic growth will curb inflation... New Zealand's economy contracted in the first quarter, putting the nation on the brink of its first recession since 1998 as drought, a slumping housing market and rising credit costs stall spending."

Bursting Bubble Economy Watch:

July 25 - Wall Street Journal (Bob Davis, Damian Paletta and Rebecca Smith): "The housing and financial crisis convulsing the U.S. is powering a new wave of government regulation of business and the economy. Federal and state governments alike are increasingly hands-on in their effort to deal with failing businesses, plunging house prices, worthless mortgages and soaring energy prices. The steps add up to a major challenge to the movement toward deregulation that has defined American governance for much of the past quarter-century since the 'Reagan Revolution' of the early 1980s. In fact, some proponents today of a bigger oversight role for government are Republican heirs to the legacy of President Reagan."

July 23 - Dow Jones (Meena Thiruvengadam): "The U.S. last month saw more mass layoffs than it has in any one month since June 2003, the Department of Labor said... There were 1,643 instances of mass layoffs affecting 165,697 workers in June..."

July 21 - Financial Times (Deborah Brewster): "US public pension funds have had their worst returns in six years, losing an average of more than 4% in the year to June 30, that puts them under even greater pressure to meet their growing liabilities. The average plan's funded status has declined by close to 5% during the year, taking it... to be only 96% funded, according to BNY Mellon. Until now funding had been improving, after five years of positive returns."

July 22 - Wall Street Journal (Christina M. Wright): "The job market for teenagers is the worst it has been in decades... A weaker summer employment market, stemming from an anemic economy and higher age requirements for many jobs, has resulted in a idle summer for many teens. Almost one in four 16- and 17-year-olds can't find work, and the Northeastern University Center for Labor Market Studies found this summer's teen employment rate could reach a postwar low."

July 22 - Financial Times (Elizabeth Rigby and Hal Weitzman): "US food companies are preparing another round of hefty price increases as soaring commodity costs force them to pass on rises to consumers. Sara Lee... said costs would compel it to push up prices on meat lines by up to a fifth later this year. 'We will be taking price increases on the vast majority of the protein products in this calendar year,' said CJ Fraleigh, Sara Lee's COO... 'Price increases vary a lot by type of products but the increases will be as low as zero and some products we will decrease on and other increases [will be] in excess of 20%.'"

Central Banker Watch:

July 22 - Wall Street Journal (Sudeep Reddy): "At least two Federal Reserve officials appear to have entered the central bank's policy meeting last month looking for a rate increase... The Fed disclosed Tuesday that the boards of two regional Fed banks -- Dallas and Kansas City -- voted in June to raise the discount rate..."

MBS/ABS/CDO/CP/Money Funds and Derivatives Watch:

July 22 - Bloomberg (Jody Shenn): "Top-rated prime-jumbo mortgage securities tumbled to record lows last week amid concern that the debt will be downgraded, according to JPMorgan... The securities fell to about $12 per $100 of principal less than similar bonds guaranteed by government-chartered Fannie Mae and Freddie Mac, compared with about $7 less the previous week... Fannie Mae's 5.5% securities trade at $96.5, data compiled by Bloomberg show. Concern that credit ratings on prime-jumbo debt may be lowered has removed a 'fair amount of bank portfolio and insurance company buyers' from the market, JPMorgan analyst John Sim wrote... Declining prices may force banks and real estate investment trusts that own the securities to write down the debt, he said. 'Certainly from a historical perspective, these levels are absurd, but any historical pricing at this point is irrelevant,' Sim wrote..."

July 22 - Bloomberg (Jeremy R. Cooke): "Moody's... move to place the Aaa ratings of Financial Security Assurance Inc. and Assured Guaranty Corp. under review for possible cuts 'may well be the end of bond insurance as we know it,' according to a Municipal Market Advisors research note. Investors probably will act as if downgrades are certain, possibly leading some money-market funds to shed variable-rate securities insured by FSA and Assured, Matt Fabian, managing director...said..."

July 21 - Wall Street Journal (Mark Maremont): "Federal officials heap much of the blame for the subprime mortgage mess on lenders, claiming they recklessly made too many high-cost home loans to borrowers who couldn't afford them. It turns out that the U.S. government itself was one of the lenders giving out high-interest, subprime mortgages, some of them predatory, according to government documents filed in federal court. The unusual situation, which is still bedeviling bank regulators, stems from the 2001 seizure by federal officials of Superior Bank FSB, then a national subprime lender based in Hinsdale, Ill. Rather than immediately shuttering or selling Superior, as it normally does with failed banks, the Federal Deposit Insurance Corp. continued to run the bank's subprime-mortgage business for months as it looked for a buyer. With FDIC people supervising day-to-day operations, Superior funded more than 6,700 new subprime loans worth more than $550 million, according to federal mortgage data. The FDIC then sold a big chunk of the loans to another bank. That loan pool was afflicted by the same problems for which regulators have faulted the industry: lending to unqualified borrowers, inflated appraisals and poor verification of borrowers' incomes, according to a written report from a government-hired expert."

July 23 - Financial Times (Paul J Davies): "The number of specialist investment managers in the European leveraged loan markets is set to drop almost as quickly as it grew, with up to 20% of firms expected to disappear over the next three years, according to Fitch... The boom in the leveraged loan market and its role in funding a wave of private equity buy-out deals in the two years before the credit crunch was only possible because of an influx of managers of structured funds called collateralised loan obligations."

Burst Mortgage Finance Bubble Watch:

July 23 - Bloomberg (Bob Ivry and Sharon L. Lynch): "Fannie Mae, the largest U.S. mortgage finance company, couldn't find a buyer who would pay $6,900 for the three-bedroom house at 1916 Prospect St. in Flint, Michigan. So broker Raymond Megie, who is handling the foreclosure sale, advised cutting the price to $5,000. Megie still couldn't sell it. 'There's oversupply,' he said. The home sold in 2005 for $110,000. Fannie Mae acquired twice as many homes through foreclosure in the first quarter as it sold, regulatory filings show... Late payments on the company's home loans, a harbinger of foreclosures, almost doubled in the past year. Together, Fannie Mae and Freddie Mac, the two biggest U.S. mortgage finance companies, owned a record $6.9 billion of foreclosed homes on March 31, compared with $8.56 billion held by all 8,500 U.S. commercial banks and savings and loans... The value of Fannie Mae's foreclosed property doubled in the first quarter to $4.72 billion from $2.4 billion a year earlier, and the number of homes it owned climbed 64% to 43,167... Fannie Mae's goal in selling its properties is to get the highest possible price, even if it means hanging on to them longer, said Gabrielle Harrison, the company's VP for REO sales... Getting the highest price helps preserve neighborhood property values, she said. 'We want to treat that home as if it was your own, or as if you were living next door to it,' Harrison said. 'You wouldn't want that home to bring down your property value.' The typical price Fannie Mae received for foreclosed homes sold in the first quarter fell to 74% of the unpaid mortgage principal from 93% in 2005, according to Harrison... Securitization of residential mortgages by underwriters outside of Fannie Mae and Freddie Mac has almost stopped. Banks bundled $1.15 trillion of home loans into so-called private-label securities in 2006, Inside Mortgage Finance reported. The number fell to $46 billion in the first half of 2008... The two government-sponsored enterprises own or guarantee 81% of U.S. mortgages originated this year... The home on Prospect Street in Flint needs a new roof and carpeting and the plumbing has been ripped out, said Megie, a broker with Realty Executive Main Street..., who sells Fannie Mae-owned homes. The house was originally listed for sale in April, he said. 'Two years ago I didn't have any Fannie Mae properties and now it's probably pushing 50% of what I have listed,' Megie said. Fannie Mae is fixing vandalized homes instead of 'just dumping them to investors,' he said."

July 22 - Wall Street Journal (Paul A. Gigot): "Angelo Mozilo was in one of his Napoleonic moods. It was October 2003, and the CEO of Countrywide Financial was berating me for The Wall Street Journal's editorials raising doubts about the accounting of Fannie Mae. I had just been introduced to him by Franklin Raines, then the CEO of Fannie, whom I had run into by chance at a reception hosted by the Business Council, the CEO group that had invited me to moderate a couple of panels. Mr. Mozilo loudly declared that I didn't know what I was talking about, that I didn't understand accounting or the mortgage markets, and that I was in the pocket of Fannie's competitors, among other insults. Mr. Raines, always smoother than Mr. Mozilo, politely intervened to avoid an extended argument, and Countrywide's bantam rooster strutted off."

Real Estate Bust Watch:

July 22 - Bloomberg (Kathleen M. Howley): "U.S. home prices fell 4.8% in May from a year earlier... The monthly house price index is down 4.9% from its peak in April 2007, the Office of Federal Housing Enterprise Oversight said..."

GSE Watch:

July 22 - Bloomberg (Dawn Kopecki): "Fannie Mae and Freddie Mac may need to record more writedowns after they expanded their purchases of non-guaranteed subprime and Alt-A mortgage securities just as other investors fled to safer investments, their regulator said. The value of $217 billion of the so-called non-agency securities is falling as other financial firms write down their holdings, the Office of Federal Housing Enterprise Oversight said in its annual mortgage market report. Privately issued securities backed by subprime mortgages made up 9.2% of the companies' combined portfolio, while Alt-A represented about 5.8%, Ofheo said. By investing 'heavily' in private-label securities in 2004 and 2005, the companies 'significantly increased their exposure to fair value losses from changes in market prices,' Ofheo said. Structured investment vehicles and securities firms, battered by $452 billion in asset writedowns and credit losses, were invested in similar securities and have contributed to the price swings that may lead to more losses at Fannie Mae and Freddie Mac under generally accepted accounting principles. 'To the extent that those institutions recognize fair value losses on their private-label portfolios under GAAP, Fannie Mae and Freddie Mac may have to do so as well,' the... regulator..."

July 21 - Bloomberg (Kathleen Hays): "Question from Kathleen Hays: 'Well in terms of the GSEs, if they're able to raise capital without help from the Treasury, does that make any difference to the mortgage market? Does it make any difference to investors like you versus a scenario where they have to do it with the government support? We know that Paulson's asking for the authority to actually purchase equity in these two agencies.' Response from Pimco's Bill Gross: 'It would make a difference. I don't think it's possible. Let's be blunt and let's be honest. To the extent that the Treasury suggests that they'll never have to use their authority, I think that's a sham. Pimco, for instance, would not invest in agency preferred stock, which is what is going to be issued, without the Treasury as a co-participant. And I don't think sovereign wealth funds would either. It's just fallacious to suggest, although it's hopeful and optimistic, to suggest that the agencies could issue capital preferred stock without the co-participation with the Treasury. I don't think that's possible."

July 22 - MarketNews International (Margaret Chadbourn): "The Congressional Budget Office... said the Treasury Department's plan to reinforce confidence in mortgage giants Fannie Mae and Freddie Mac could cost about $25 billion during the next two years. However, Peter Orszag, director of the COB said in a letter to lawmakers there is a 'significant chance -- probably better than 50% -- that the proposed new Treasury authority would not be used before it expired at the end of December 2009... On the other hand, 'Many analysts and traders believe that there is a significant likelihood that conditions in the housing and financial markets could deteriorate more than already reflected on the GSEs' balance sheets, and such continuing problems would increase the probability that this new authority would have to be used...' The CBO said there is a 5% chance that the mortgage lenders' losses would cost the government $100 billion..."

July 21 - Wall Street Journal: "You'll love this one. In the strange accountability of Washington, the same folks who put taxpayers on the hook for Fannie Mae and Freddie Mac are now demanding ransom to let taxpayers bail them out. It's as if Andy Fastow insisted that Enron shareholders pay his fines after his fraud cost them their life savings. 'I don't know how in good conscience you come up here and ask me to give unlimited lines of credit' to Treasury for Fannie and Freddie without giving Democrats something in return, Senate Banking Chairman Christopher Dodd told the Journal last week. Come again? This is the same Chris Dodd who long resisted tougher regulation while more recently handing Fan and Fred even more room to expand their risk-taking."

July 22 - Bloomberg (Anthony Massucci): "Federal Reserve Bank of Philadelphia President Charles Plosser commented on the Fed's 'limited' role with the two largest sources of U.S. mortgage financing, Fannie Mae and Freddie Mac, and financial regulation... 'On the moral hazard question, all we have to do is look at Fannie and Freddie to the extent that they create more problems then they already have and this is the manifestation of moral hazard and it is real. I think we need to recognize that the consequences of creating institutions or taking actions as policy makers that create moral hazards does have consequences. Sometimes it's way down the road somewhere and it does have consequences. And I think this is just evidence of exactly that problem.'"

Speculator Watch:

July 21 - Bloomberg (Clare Cheung): "Fortress Investment Group LLC 's mortgage fund is down 30% in three months as investors leave the mortgage sector on concerns about mortgage defaults... The U.S. private equity and hedge fund company, which oversees $43 billion, raised $560 million for the fund, Fortress Mortgage Opportunities, by buying triple-A-rated residential mortgage-backed securities this spring, the report said."

Fiscal Watch:

July 23 - Bloomberg (William Selway): "U.S. state governments cut spending on schools and health care, tapped reserves and borrowed to close $40 billion of budget gaps that emerged as the economy slowed, according to a report by a state lawmakers group. New York and Virginia were among the 10 states that trimmed spending across the board for the budget year that began this month for all but four states, the report released today by the National Conference of State Legislatures found. Seven of the 31 states with fiscal 2009 deficits raised taxes."

California Watch:

July 22 - Bloomberg (Daniel Taub): "California mortgage defaults more than doubled in the second quarter to a 16-year high as falling sales and prices prevented some homeowners from selling their properties to pay off loans, DataQuick...said. California homeowners received 121,341 default notices in the second quarter, up 125% from a year ago... The level was the highest since at least 1992, when DataQuick's statistics begin. Second-quarter defaults were up 6.6% from the previous three months."

July 18 - Bloomberg (Michael B. Marois): "The California Public Employees' Retirement System, the largest U.S. public pension fund, said it lost 2.4% in the 12 months ended June 30, as stock declines caused its worst performance in six years. The performance of the fund, with $239 billion in assets, compared with a 19% gain in the previous fiscal year. Calpers, as the fund is known, said its stock portfolio lost 10.7%."

Muni Watch:

July 24 - Wall Street Journal (Conor Dougherty, Amy Merrick and Anton Troianovski)): "The stumbling U.S. economy is forcing states to slash spending and cut jobs in order to close a projected $40bn shortfall in the current fiscal year. That gap -- identified Wednesday in a survey by the National Conference of State Legislatures -- is more than triple the size of the previous year's. It is the result of broad economic weakness at the state and local levels that could cause pain throughout this year and into 2010. Sales-tax collections, for example, have been hurt by the housing slump and high gasoline prices, which are prompting cutbacks in consumer spending. Personal income-tax collections have been hit by rising unemployment, while corporate income-tax collections have been eroded by falling profits. 'We expect it to get worse before it gets better,' said Corina Eckl, ...director of the National Conference of State Legislatures."

Crude Liquidity Watch:

July 22 - Bloomberg (Fiona MacDonald and Matthew Brown): "Kuwaiti inflation accelerated to a record 11.4% in April... The inflation rate rose from 10.2% in March as housing costs increased an annual 14.9% and food rose 11.9%..."

July 22 - Bloomberg (Will McSheehy): "Islamic corporate bond sales in the Persian Gulf rose 17% to $17 billion in the year to June 30 as oil revenue spurs expansion in the region, according to law firm Trowers & Hamlins."

July 24 - Bloomberg (Matthew Brown): "Dubai residential rents rose an annual 22% in the second-quarter as occupancy rates increased, Emirates Business 24/7 reported..."

A GSE Perspective:

On more than a few occasions over the years I've been accused of having an obsession with the GSEs. For some time I've viewed these institutions as the key linchpins for a historic Credit Bubble along the lines of John Law's eighteenth-century Mississippi Bubble. The GSEs, with their implied government backing, forged a fundamental - and momentous - change in the nature of contemporary "money" and Credit. Their financial and economic impact has expanded exponentially since their initial foray into system liquidity backstop operations back with their 1994 bond market/hedge fund "bailout." I am left to scoff at the CBO's $25bn estimate for the likely eventual cost to the American taxpayer.

Fannie's and Freddie's combined Total Assets ended 1991 at $194bn, only to about double in four years before ending the nineties at $962bn. After several years of aggressive growth, Fannie's and Freddie's combined Books of Business (retained holdings and MBS guarantees) began 1999 at about $1.60 TN. In May of this year they exceeded an incredible $5.20 TN and have so far this year expanded at near y-t-d double-digit rates. Over the past 12 months (through May), Fannie and Freddie's combined Book of Business had expanded $627bn, or 13.7%.

When I read the various estimates of the GSEs' additional capital requirements, I again reflect back to one of the great flaws in economic historical revisionism with respect to the Great Depression. Conventional ("revisionist") thinking today has it that if the Fed had simply "printed" $5bn and replenished lost banking system capital in the early thirties, the worst effects of the depression would have been avoided. But then, as is the case today, the size of lost financial sector "capital" was not the critical issue. Instead, financial sector losses pale in comparison to the huge scope of additional Credit creation necessary to sustain deeply maladjusted financial and economic structures - and the impossibility of sustaining Credit Bubble excess in the face of escalating risk intermediation losses and resulting tightened financial conditions, sinking asset prices, acute financial system impairment, investor and speculator revulsion, de-leveraging, major changes from boom-time spending patterns and economic downturn.

Treasury and the Fed could today easily "cut" Fannie and Freddie (and the FHLB!) a $20bn check or, ok, $50bn. Yet the reality of the situation is that GSE "Books of Business" must expand at least $600bn this year and then as much next year and the year after that... or very serious problems will unfold throughout the conventional mortgage marketplace. There are Minskian "Ponzi Finance" dynamics at work here, as there were in subprime, "private-label" MBS, CDO, auction-rate and other markets. Only the stakes of a conventional mortgage bust are much greater.

Without the GSEs, there is no way Total U.S. Mortgage Debt would have doubled in the six years 2001-2006. Without the GSEs, it would have been impossible for broker/dealer assets to have ballooned from $455bn to begin 1995 to $3.10 TN to end 2007. And I believe very strongly that without the GSEs the leveraged speculating community would be but a fraction of its current unfathomable size.

Many view the GSEs in an ideological context. To me, it's always been at its core a financial, economic and political issue - one of the most important issues of our day that Washington and the Fed have left in complete shambles. With the GSEs' quasi-governmental status, the markets have merrily assumed GSE obligations would be, if necessary, backed by the full faith and Credit of the U.S. government. It remains an irrepressible Bubble.

Washington (democratic and republican administrations, congress, and the Federal Reserve) and Wall Street were happy to live/thrive with the grey area of the markets' acceptance of implied government backing. Importantly, this market perception granted the GSEs the extraordinary capacity to create at will contemporary "money" (financial instruments perceived as being safe and liquid) and (extraordinarily appealing) Credit. This "moneyness" of GSE obligations played an instrumental role in profound changes experienced throughout the financial and economic world over the past 15 years. Never in history has an inflationary mechanism enjoyed such capacity to issue endless quantities of "money-like" instruments with nary a public protest or market backlash (at least as long as asset prices were inflating). And even recently, despite heightened market concerns, Freddie was not impeded from expanding its retained portfolio $21bn during June, or 33% annualized.

The markets' enthusiastic embrace of massive issuance during bouts of financial market tumult encompassed the greatest danger inherent in GSE obligation "moneyness". GSE assets expanded 15% ($115bn) during the 1994 crisis, 28% ($305bn) during tumultuous 1998, 23% ($317bn) during 1999, and another 18% ($344bn) during the corporate Credit crisis of 2001. And keep in mind that Fannie's and Freddie's combined Books of Business have ballooned more than $3.1 TN so far this decade.

Enjoying unlimited access to borrowings during periods of systemic stress, the GSEs evolved into the powerful liquidity backstop for the leveraged speculating community and the securities markets generally. Like clockwork, the Greenspan Fed would aggressively cut rates and the GSEs would aggressively expand Credit. And without the GSEs as buyers eager to pay top dollar for mortgages and MBS - especially in the event of marketplace disruption - the hedge funds, Wall Street proprietary trading desks, and others would never have had the gumption to accumulate highly leveraged positions throughout the mortgage and debt securities marketplace. Speculator profits would not have been as spectacular and certainly not consistently so; the unrelenting fund flows feeding the speculator community Bubble would have been a trickle or perhaps a stream as opposed to what evolved into a historic flood. Today's massive and destabilizing Global Pool of Speculative Finance owes its existence to the GSEs.

If it weren't for the GSE's, the 1998 LTCM crisis would have burst a number of fledgling Bubbles, certainly those gaining momentum in technology stocks and telecom debt and most likely in securitizations more generally. The year 1999 would have been a recession year, rather than one noted for spectacular stock market gains. The GSEs again played a major role in ensuring that the 2001/02 recession was short and shallow - that unfolding excesses and imbalances were validated rather than corrected. The GSEs, along with their Wall Street comrades, ensured that each year would bring only greater amounts of system Credit and resulting higher asset prices higher than the year before. Resulting economic and asset market "resiliency" spurred an increasing variety of Credit instruments and channels - mostly "AAA" - that provided more than sufficient fuel for the U.S. Bubble economy.

I have repeatedly expounded the view that the most problematic systemic damage over this protracted Credit boom has been inflicted upon the underlying structure of the U.S. economy. It is my view that only through the interplay of GSE and Wall Street "structured finance" Bubble dynamics has our massive Current Account Deficit been sustainable. It was this Credit apparatus that created much of the "money-like" financial claims that our economy has for too long traded for imported energy and goods. And each year that foreigners eagerly accepted these claims brought deeper mal-investment and structural impairment. The GSEs provided a "backstop bid" to the speculators and foreign central banks provided a "backstop bid" for the Trillions of agency instruments and dollar financial claims more generally. U.S. and global imbalances went to unprecedented extremes. Most regrettably, the evolution to our finance-driven, "services," asset and consumption-based economy has been a direct byproduct of the GSE/Wall Street Credit boom.

As the Credit Bust has broadened and worsened, GSE solvency has become a critical marketplace issue. Today, with the specter of acute GSE financial fragility, the "moneyness" of GSE obligations now rests 100% with unlimited federal government backing. Treasury has few options than the game it's playing (Bill Gross used "sham"). The hope is that with Congress providing Treasury with blank check discretion to recapitalize the GSEs, agency obligations will retain the confidence of the marketplace. It worked somewhat this week, as agency debt spreads narrowed significantly. But why, then, are agency MBS spreads remaining so wide?

Mortgages have traditionally been a rather unattractive investment instrument. Real estate markets are traditionally highly cyclical, with risk under-pricing during the boom and Credit losses exploding in subsequent downturns. Moreover, there's major interest rate risk. When rates decline, homeowners rush to refinance and the holders of these mortgages suffer prepayment risk (must reinvest proceeds at lower rates). When interest rates rise, homeowners hold onto their attractive mortgages longer - and the holder gets stuck with longer duration.

Yet despite these less than enticing attributes, mortgages became only more coveted during each year throughout the life of the Credit Bubble - with, of course, the booms in the GSE and Wall Street finance playing an instrumental role in the newfound status of this asset class. A strong case can be made today that the dynamics of this asset class have changed once again - and profoundly. Mortgages are poised to be unappealing for years to come.

Capital raising notwithstanding, the GSEs will now be indefinitely and severely equity capital constrained (at best). Their days of mortgage/MBS "buyers of first and last resort" will be drawing to a conclusion. Capital requirements for guaranteeing MBS are significantly less onerous, so Fannie and Freddie will have little alternative than to rein in balance sheet growth (MBS retention) while continuing to guarantee massive agency MBS issuance ("insurer of last resort"). This cannot be a comforting dynamic for those that have had been making a nice living leveraging in MBS. Meanwhile, the "private-label" MBS market is an unmitigated bust and even bank "prime" mortgage lending appears to have tightened meaningfully, further restraining mortgage Credit growth and placing ongoing downward pressure on home prices and the general economy. This Credit bust dynamic greatly exacerbates GSE portfolio Credit risk, while leaving them with no alternative than to continue to aggressively expand their MBS guarantee business (to the tune of $600bn plus annually in the face of an escalating housing and economic bust).

The GSEs are now trapped in a precarious riptide where they must swim incredibly hard to barely tread water. This is an extremely tenuous position for the conventional mortgage marketplace, not to mention the increasingly credit-starved U.S. Bubble economy.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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