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August 15, 2008

Dysfunctional Pricing Backdrop
by Doug Noland

For the week, the Dow dipped 0.6% (down 12.1% y-t-d), while the S&P500 added 0.1% (down 11.6%). The Morgan Stanley Cyclical index added 0.6% (down 10.6%), and the Morgan Stanley Consumer index gained 1.2% (down 4.1%). The Utilities (down 13.3%) and Transports (up 12.8%) each declined 1.2%. The broader market was much stronger. The small cap Russell 2000 jumped 2.6% (down 1.7%), and the S&P400 Mid-Caps rose 1.0% (down 4.2%). Technology continues to outperform. The NASDAQ100 gained 1.6% (down 6.1%), and the Morgan Stanley High Tech index added 0.6% (down 5.8%). The Semiconductors jumped 2.5% (down 7.7%). The Street.com Internet Index increased 1.2% (down 3.6%), and the NASDAQ Telecommunications index gained 1.0% (down 0.2%). The Biotechs jumped 3.0%, increasing y-t-d gains to 12.3%. The Broker/Dealers dropped 2.8% (down 27.5%), and the Banks fell 3.1% (down 25.3%). With Bullion sinking $70, the HUI Gold index fell 5.7% (down 22.9%).

One-month Treasury bill rates rose 6 bps this week to 1.72%, and 3-month yields jumped 10 bps to 1.83%. Two-year government yields fell 11 bps to 2.39%. Five-year T-note yields declined 10 bps to 3.10%, and 10-year yields dropped 9 bps to 3.84%. Long-bond yields declined 7 bps to 4.47%. The 2yr/10yr spread widened 2 bps to 145 bps. The implied yield on 3-month December '09 Eurodollars sank 15 bps to 3.66%. Benchmark Fannie MBS yields declined 3 bps to 5.96%. The spread between benchmark MBS and 10-year Treasuries widened a notable 7 to 212 bps. The spread on Fannie's 5% 2017 note widened 5 bps to 81 bps, and the spread on Freddie's 5% 2017 note widened 6 bps to 82 bps. The 10-year dollar swap spread increased 0.25 to 74.25. Corporate bond spreads were mostly wider. An index of investment grade bond spreads widened one to 145 bps, and an index of junk bond spreads widened 17 bps to 577 bps.

August 13 - Bloomberg (Dawn Kopecki): "Fannie Mae sold $3.5 billion of three-year benchmark notes, paying investors the highest yield in at least six years after last week reporting a wider-than- estimated loss. The 3.625% notes...were priced to yield 3.642%, or 122.5 bps more than U.S. Treasuries..."

Investment grade issuance this week included AIG $3.2bn, Citigroup $3.0bn, American Express $2.0bn, Ingersoll-Rand $1.6bn, Southern Co. $600 million, Southern Cal Edison $400 million, and Entergy $300 million.

I saw no junk issuance this week.

Convert issuers this week included Boston Properties $650 million, Brunswick $250 million, and Ferro $150 million.

International dollar bond issuance included Deutsche Telekom $1.5bn and Caribbean Restaurants $150 million.

August 13 - Bloomberg (William Mauldin): "Russia's RTS stock index is turning into the world's worst performer this quarter as tumbling oil, a war in Georgia and the probe of a steel company remind investors owning shares in the former Communist nation can be perilous. The RTS fell 22% since June 30..."

German 10-year bund yields sank 11 bps to 4.15%. The German DAX equities index declined 1.8% (down 20.1% y-t-d). Japanese 10-year "JGB" yields slipped 1.5 bps to 1.455%. The Nikkei 225 fell 1.1% (down 14.9% y-t-d). Emerging markets were mixed to mostly lower. Brazil's benchmark dollar bond yields declined 2 bps to 5.90%. Brazil's Bovespa equities index sank 4.1% (down 15.1% y-t-d). The Mexican Bolsa added 0.8% (down 7.4% y-t-d). Mexico's 10-year $ yields added 3 bps to 5.47%. Russia's RTS equities index rallied 3.6% (down 22.1% y-t-d). India's Sensex equities index fell 2.6%, boosting y-t-d losses to 27.4%. China's Shanghai Exchange index sank 6.0%, with 2008 losses rising to 53.4%.

Freddie Mac 30-year fixed mortgage rates were unchanged again this week @ 6.52% (down 10bps y-o-y). Fifteen-year fixed rates dipped 3 bps to 6.07% (down 23bps y-o-y), while one-year ARMs declined 4 bps to 5.18% (down 49bps y-o-y). Meanwhile, Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates up 3 bps this week to 7.53%.

Bank Credit declined $6.3bn to $9.399 TN (week of 8/6). Bank Credit has expanded $186bn y-t-d, or only 3.3% annualized. Bank Credit posted a 52-week rise of $703bn, or 8.1%. For the week, Securities Credit dropped $18.9bn. Loans & Leases increased $12.6bn to $6.930 TN (52-wk gain of $547bn, or 8.6%). C&I loans slipped $1.3bn, with y-t-d growth of 8.4%. Real Estate loans grew $3.5bn (up 1.9% y-t-d). Consumer loans added $0.6bn, while Securities loans declined $1.1bn. Other loans jumped $10.9bn.

M2 (narrow) "money" supply declined $8.2bn to $7.721 TN (week of 8/4). Narrow "money" has expanded $258bn y-t-d, or 5.8% annualized, with a y-o-y rise of $433bn, or 5.9%. For the week, Currency was about unchanged, while Demand & Checkable Deposits rose $13.2bn. Savings Deposits dropped $25.2bn, while Small Denominated Deposits gained $7.6bn. Retail Money Funds fell $4.4bn.

Total Money Market Fund assets (from Invest Co Inst) rose $14.1bn to $3.575 TN, with a y-t-d increase of $461bn, or 24.1% annualized. Money Fund assets have posted a one-year increase of $874bn (32.4%).

Asset-Backed Securities (ABS) issuance slowed to virtually nothing this week. Year-to-date total US ABS issuance of $120bn (tallied by JPMorgan's Christopher Flanagan) is running at 26% of comparable 2007. Home Equity ABS issuance of $303 million compares with 2007's $215bn. Year-to-date CDO issuance of $17bn compares to the year ago $265bn.

Total Commercial Paper outstanding jumped $21.4bn this week to $1.747 TN, with a y-t-d decline of $38.7bn (3.4% annualized). Asset-backed CP fell $5.2bn last week to $725bn, boosting 2008's decline to $48.3bn (9.8% annualized). Over the past year, total CP has contracted $386bn, or 18.1%, with ABCP down $422bn, or 36.8%.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 8/13) dipped $0.8bn to $2.395 TN. "Custody holdings" were up $338bn y-t-d, or 25.9% annualized, and $390bn y-o-y (19.5%). Federal Reserve Credit contracted $6.2bn to $883bn. Fed Credit has expanded $9.5bn y-t-d (1.7% annualized) and $15.2bn y-o-y (1.8%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.302 TN y-o-y, or 23%, to a record $6.996 TN.

Global Credit Market Dislocation Watch:

August 12 - Bloomberg (Yalman Onaran): "Banks' losses from the U.S. subprime crisis and the ensuing credit crunch crossed the $500 billion mark as writedowns spread to more asset types. The writedowns and credit losses at more than 100 of the world's biggest banks and securities firms rose after UBS AG reported second-quarter earnings today, which included $6 billion of charges on subprime-related assets... 'It just keeps spreading from one asset to another, so it's hard to know when these writedowns will stop,' said Makeem Asif, an analyst at KBC Financial Products..."

August 12 - Wall Street Journal (Sudeep Reddy): "More banks are tightening their standards for lending to consumers and businesses, a sign that the credit crunch could weigh on the economy into next year. The Federal Reserve's survey of senior loan officers... found banks growing more cautious in their lending to consumers. Two-thirds of domestic banks tightened lending terms between April and July for credit cards and other consumer loans. That was up from roughly a third of banks tightening credit-card loans in the prior three-month period, and almost half of banks tightening standards for other loans. Banks also are increasingly raising minimum credit scores for consumer loans and lowering credit limits on credit-card accounts... The Fed survey, conducted in July and released Monday, found 60% of domestic banks expected to tighten standards on credit-card loans in the second half of the year, and more than a third expected to tighten those standards in the first half of next year."

August 12 - CNNMoney (Les Christie): "Prime mortgages are starting to record disturbingly high default rates, which could slow any potential housing recovery. The delinquency rate for prime mortgages worth less than $417,000 was 2.44% in May, compared with 1.38% during May of 2007, according to LoanPerformance... Delinquencies jumped even more for prime loans of more than $417,000, so called jumbo loans. They rose to 4.03% of outstanding loans in May, compared with 1.11% a year earlier. And prime loans issued in early 2007 are performing the worst of all, failing at a rate nearly triple that of prime loans issued in 2006... 'The extent of how bad these loans are doing is very troubling,' said Pat Newport, real estate economist with Global Insight..."

August 11 - Wall Street Journal (Robert Tomsho): "A retreat by private-sector lenders from the market for education loans is threatening to keep thousands of students out of college in the coming academic year. About 10% of the nine million student borrowers in the U.S. seek such private loans, which supplement the limited amounts available from government-aid programs. Over the past decade, as government grants and loans have failed to keep pace with rising tuitions, private-loan borrowing has increased more than tenfold to $17.1 billion annually... Lenders have cut back on making such loans as investors have shunned the securities they rely upon to raise lending capital."

August 15 - Bloomberg (Thomas R. Keene and Daniel Kruger): "Mohamed El-Erian, co-CEO of Pimco, said it has become harder for financial firms to raise capital because investors such as sovereign wealth funds have gotten 'smarter.' 'We are in the process of a major adjustment of the banking system which is made harder because you don't have the capital to lubricate it,' El-Erian said..."

August 11 - Wall Street Journal (Mark Maremont): "Five of the nation's largest credit unions are reporting big paper losses on mortgage-related securities, a sign that housing-market distress is spreading even to the most risk-averse financial sectors. The federal regulator overseeing credit unions says the losses are likely to be reversed when mortgage markets stabilize... But some outside observers are concerned that the credit unions are underestimating the depth of their mortgage-market problems..."

August 14 - Bloomberg (Caroline Salas): "Bond investors are underestimating how quickly high-yield debt defaults will rise over the next year, according to Martin Fridson, CEO of Fridson Investment Advisors. 'The bottom line is we expect many investors are in for a rude shock over the next year as high-yield bonds default in higher numbers than they expect,' Fridson... said... 'The high-yield market is entering the up-leg of the default rate cycle with a far worse quality mix than the last time around... It is hard to give much credence to optimists who forecast a substantially lower peak default rate in this cycle than the 10.89% rate reported by Moody's... for January 2002.'"

August 13 - Wall Street Journal (Phil Izzo): "Banks continue to have a healthy thirst for funding, as longer-dated, dollar-denominated auctions by the Federal Reserve, the European Central Bank and the Swiss National Bank received strong interest. The $25 billion, 84-day term auction facility offered by the Fed drew $54.8 billion of bids from 64 banks. A total of 57 banks bid $38.52 billion for $10 billion offered by the ECB in 84-day funds, while 15 participants bid $9.8 billion for the Swiss central bank's $2 billion auction. The interest rate on the Fed auction was unexpectedly high at 2.754%."

August 14 - Bloomberg (Adam L. Cataldo): "The return for all institutional investment portfolios turned negative for the 12 months ended June 30, the first annual loss since March 2003. The median contraction for master trusts, which includes pension plans, foundations and endowments, was 4.49% during the year, according to the survey released today by the Wilshire Trust Universe Comparison Service. 'Even the larger plans with a greater allocation to alternatives were not immune from the impact of worldwide market volatility during the past year,' Hilarie Green, the head of Wilshire Analytics' Performance Reporting Division, said..."

August 14 - Bloomberg (Abigail Moses): "General Motors Corp. bondholders may lose as much as 73% in the event of a default by the world's biggest automaker, based on the price of contracts used to fix a recovery value for the securities. The recovery swap rate on GM dropped to 26.5%, from 39.5% at the end of June, meaning investors expect to get only 26.5 cents on the dollar in an insolvency, CMA Datavision pricing models show."

August 14 - Bloomberg (Bob Van Voris): "Wachovia Corp.'s BluePoint Re Ltd. unit, which insures structured finance and municipal transactions, filed for bankruptcy protection, citing defaults on securitized mortgages. BluePoint filed a petition in Manhattan yesterday..."

Global Inflation Turmoil Watch:

August 12 - Bloomberg (Farhan Sharif): "Pakistan's inflation accelerated to a 30-year high in July... Consumer prices in South Asia's second-largest economy jumped 24.33% from a year earlier after soaring 21.53% in June..."

August 11 - Bloomberg (Mahmoud Kassem): "Egyptian inflation rose to an annual 22% in July, the highest since 1992..."

Currency Watch:

The dollar index gained 1.8% to 77.18. For the week on the upside, the New Zealand dollar gained 1.0% and the Canadian dollar 0.9%. For the week on the downside, the British pound declined 2.4%, the Australian dollar 2.0%, the Euro 1.5%, the Danish krone 1.5%, the Swedish krona 1.1%, the Swiss franc 0.9%, and the Norwegian krone 0.9%.

Commodities Watch:

What a rout. Gold sank 8.2% to $786, and Silver collapsed 15.9% to $12.89. September Crude declined $1.46 to $113.70. September Gasoline dipped 1.1% (up 15.5% y-t-d), while September Natural Gas fell 2.7% (up 7.9% y-t-d). September Copper was little changed. September Wheat rose 7.7%, and August Corn gained 6.3%. The CRB index declined 1.3% (up 6.6% y-t-d). The Goldman Sachs Commodities Index (GSCI) dipped 0.7% (up 14.6% y-t-d and 40% y-o-y).

China Watch:

August 11 - Bloomberg (Nipa Piboontanasawat): "China's producer prices climbed at the fastest pace since 1996 on energy and commodity costs... Factory-gate prices rose 10% in July from a year earlier... after gaining 8.8% in June..."

August 13 - Bloomberg (Nipa Piboontanasawat): "China's money-supply growth slowed for a second month... M2... rose 16.35% from a year earlier to 44.64 trillion yuan ($6.5 trillion)..."

August 13 - Bloomberg (Paul Panckhurst and Nipa Piboontanasawat): "China's retail sales expanded at the fastest pace in at least nine years in July as incomes and prices climbed in the world's fastest-growing major economy. Sales rose 23.3% to 862.9 billion yuan ($126bn) after gaining 23% in June..."

August 12 - People's Daily (Robert Tomsho): "China's total value of foreign trade reached approximately 1.482 trillion USD by the end of July this year, growing by 26.4% over the same period of last year..."

Japan Watch:

August 13 - Bloomberg (Jason Clenfield): "Japan's economy, the world's second biggest, contracted last quarter as exports fell and consumers spent less, bringing the country to the brink of its first recession in six years. Gross domestic product shrank an annualized 2.4% in the three months ended June 30 after expanding 3.2% in the first quarter..."

August 11 - Bloomberg (Toru Fujioka): "Japanese consumers became the most pessimistic they've been in at least 26 years..."

August 12 - Bloomberg (Mayumi Otsuma): "Japan's wholesale inflation rate accelerated to a 27-year high in July... Producer prices climbed 7.1% from a year earlier, after a revised 5.7% increase in June..."

August 13 - Financial Times (Michiyo Nakamoto): "Japan has had little to do with the US subprime mortgage debacle and has avoided a UK-style housing bubble, but the country's real estate sector is suffering a painful credit crunch. In the past few months, an increasing number of real estate companies have gone under. In July, 43 developers filed for bankruptcy, a year-on-year increase of 79%... The bankruptcies were largely triggered by a failure to access funds..."

August 13 - Bloomberg (Kathleen Chu and Oliver Biggadike): "Urban Corp., Japan's worst-performing real-estate stock in 2008, filed for protection from creditors with debt of 255.8 billion yen ($2.35bn), making it the largest bankruptcy among listed companies in the nation this year."

India Watch:

August 14 - Bloomberg (Kartik Goyal): "India's inflation soared to a 16- year high and may accelerate further after the government approved wage increases for civil servants. Wholesale prices rose 12.44% in the week to Aug. 2..."

August 13 - Bloomberg (Kartik Goyal and Cherian Thomas): "India's central bank will need to keep monetary policy 'tight' as inflation is likely to accelerate further from a 13-year high, Prime Minister Manmohan Singh's economic advisory panel said... 'Inflation will remain high in the next few months and could rise to 13%,' Chakravarthi Rangarajan, the outgoing head of the panel, told reporters..."

August 11 - Bloomberg (Vipin V. Nair and Kartik Goyal): "India's passenger car sales declined for the first time in more than two and a half years as higher interest rates and accelerating inflation damped demand..."

Asia Bubble Watch:

August 14 - Bloomberg (Seyoon Kim): "South Korea's import prices jumped by the most in more than a decade in July as oil costs climbed. Prices of imported goods surged 50.6% from a year earlier..."

August 13 - Financial Times (John Burton): "Economic growth slowed in the second quarter in Singapore to 2.1% from a year ago, providing fresh evidence that the US slowdown is beginning to affect Asian economies."

Latin America Watch:

August 14 - Bloomberg (Fabiola Moura): "Wal-Mart Stores Inc., the third- biggest retailer in Brazil, will invest as much as 1.8 billion reais ($1.1 billion) in the country in 2009, a 50% increase from the 1.2 billion reais planned this year."

August 14 - Bloomberg (Brendan Walsh): "Panama's consumer prices rose 9.6% in July from a year earlier, the Controller General reported..."

Unbalanced Global Economy Watch:

August 13 - Bloomberg (Jennifer Ryan): "U.K. unemployment rose the most in almost 16 years in July and wage growth slowed as the deepening economic slowdown drove companies to cut jobs and hold down pay. Claims for jobless benefits climbed 20,100 from June to 864,700..."

August 12 - Bloomberg (Svenja O'Donnell): "U.K. inflation accelerated to more than double the central bank's 2% target in July... Consumer prices rose 4.4% from a year earlier..."

August 11 - Bloomberg (Brian Swint): "U.K. producer prices increased in July at the fastest pace since records began in 1986, adding to pressure on the Bank of England to wait before cutting interest rates as the economy edges toward a recession. Prices charged by factories rose 10.2% from a year earlier..."

August 14 - Bloomberg (Fergal O'Brien and Christian Vits): "Europe's economy contracted in the second quarter for the first time since the launch of the euro almost a decade ago... Gross domestic product fell 0.2% from the first quarter... Separate figures showed inflation held at 4% in July, less than initially estimated."

August 14 - Bloomberg (Simone Meier): "The French economy contracted for the first time in more than five years in the second quarter as exports declined and companies cut spending."

August 11 - Bloomberg (Tasneem Brogger): "Danish inflation accelerated to 4% in July, the fastest pace in 18 1/2 years..."

August 13 - Reuters: "Spain's July inflation topped forecasts to hit a 15-year high, making a severe slowdown in the economy more painful. Surging fuel and food costs pushed year-on-year inflation to 5.3%..."

August 13 - Bloomberg (Ott Ummelas): "Estonia's economy contracted the most in almost 14 years in the second quarter, becoming the second European Union economy to enter a recession since the start of the global credit crunch."

August 13 - Bloomberg (Jacob Greber): "Australian wages growth unexpectedly accelerated in the second quarter at the fastest pace in 11 years, underlining the central bank's concern that rising salaries may stoke inflation..."

August 12 - Bloomberg (Tracy Withers): "Sales of New Zealand houses fell 33% from a year earlier in July..."

Bursting Bubble Economy Watch:

August 15 - Bloomberg (Courtney Schlisserman): "Florida and Georgia had the biggest job losses in July, reflecting declines in construction, tourism, retail and transportation. The payroll count in Florida dropped by 21,400 last month, led by a 9,600 decline in construction and a 4,600 drop in leisure and hospitality... Employers in Georgia cut 18,900 workers..."

August 13 - Bloomberg (Alex Ortolani): "Auto parts machine operator Marty Shawl was so shaken by the bankruptcy of his former employer Delphi Corp. that he paid off credit cards, canceled an annual trip to Canada and sold his all-terrain vehicle for $1,000 less than the $5,000 he paid for it. 'Once I got it in my mind to sell it, that was it,' said Shawl... 'We're economizing. I won't be buying things like that anymore.' Shawl said he was looking for a simpler and less expensive lifestyle -- and there are plenty of other ex-autoworkers making a similar transition by choice or necessity. The auto industry workforce has shrunk to almost half its size since 2000."

August 13 - Market News International (Claudia Hirsch): "That morning shower is getting costlier, as personal care product prices rise in tandem with ingredient commodities, packaging and transportation costs, according to manufacturers, retailers and consumers. A wide array of personal care items have been sporting higher price tags in recent months, due in no small part to lofty oil prices that inject inflation into every link of the supply chain, from the raw materials to the trucks that deliver the finished goods to retailers, industry participants said... 'Since the beginning of the year, we've been in hyper-inflation mode,' said Kevin Mallory, president of Formulab, a contract manufacturer of private-label personal care products... 'All of our raw materials are derived from either petroleum or vegetable oils, and both of those have gone through the roof,' said Mallory... The result is a minimum 30% increase in Formulab's finished product prices so far this year, while some product prices have doubled."

August 13 - Associated Press (Donna Borak): "Lockheed Martin Corp. says a double-digit jump in the cost of steel and rising oil prices have helped propel the final price tag of its latest warship for the Navy to more than double the initial estimates. Navy officials last month told lawmakers the service's initial estimate of $220 million per ship had ballooned to as much as $550 million..."

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

August 13 - CNNMoney (Les Christie): "More homeowners than ever are selling at a loss, propelling the real estate market deeper into crisis. In the 12 months that ended June 30, nearly 25% of all homes sold nationwide fetched less than sellers originally paid, according to... Zillow.com. While the nation's double-digit decline in home prices has been well documented, the new report underscores the economic force of those price declines. Homeowners are walking away with much less in their pocket when they sell... 'It's stunning what's happening out there,' said Stan Humphries, Zillow's vice president of data and analytics... 'The numbers are the worst we've seen and it's not just the magnitude of the problem but the scope - so many markets are affected.'"

August 13 - Financial Times (Sarah Mishkin): "Efforts to avert foreclosures are being complicated by the large number of subprime borrowers who took out second mortgages so they could afford the downpayments on their homes, industry executives say. George W. Bush... signed a bill last month providing $300bn to help distressed homeowners refinance into cheaper mortgages backed by the Federal Housing Administration. In exchange for agreeing to a loss on the initial loan, primary lenders are guaranteed a minimum pay-out while the second mortgage would be wiped out. Second-mortgage providers are generally in a weaker position than primary lenders in a renegotiation because they hold what is known as a second lien... However, industry executives say secondary lenders are finding ways to stall or derail mortgage renegotiations, employing such methods as delaying the completion of necessary paperwork."

Real Estate Bust Watch:

August 14 - Bloomberg (Dan Levy): "Bank repossessions almost tripled in July and U.S. foreclosure filings increased 55% from a year earlier as falling prices cut homeowner equity, accelerating the housing decline, RealtyTrac Inc. said. Bank seizures rose 184%... More than 272,000 properties, or one in 464 U.S. households, got a default notice, was warned of a pending auction or were foreclosed on. Nevada, California and Florida had the highest rates. 'It's getting worse,' Rick Sharga, RealtyTrac's executive vice president... said... 'The number of properties that have been foreclosed on by the banks and still haven't sold is the highest we've ever seen.' Total filings rose 8% from the previous month..."

August 14 - Bloomberg (Kathleen M. Howley and Dan Levy): "Existing U.S. home sales fell to a 10-year low in the second quarter and the median price for a single-family house dropped 7.6 percent as the real estate recession deepened. The median price tumbled to $206,500 from $223,500 a year earlier, the Chicago-based National Association of Realtors said... Sales of single-family houses and condominiums fell 16% to 4.913 million at an annualized pace."

August 14 - Bloomberg (Sharon L. Lynch): "Office vacancy rates climbed in the second quarter as U.S. jobless claims rose and losses and writedowns at financial firms surpassed $252 billion in the Americas. Vacancies in central business districts from Boston to Orange County, California, averaged 10.2% compared with 9.7% a year earlier, according to... Cushman & Wakefield..."

GSE Watch:

August 15 - Bloomberg (Brendan Murray and John Brinsley): "Investors in Japan and China scaled back purchases of Fannie Mae and Freddie Mac's debt in June, a month before U.S. Treasury Secretary Henry Paulson announced plans to bail out the two mortgage financiers. Private and government investors in Japan slowed purchases of agency debt to $770 million in June, from $4.5 billion a month earlier... China bought $9.6 billion in Fannie Mae and Freddie Mac debt, down from $14.9 billion in May."

August 12 - Dow Jones (Jessica Holzer and Michael Crittenden): "Fannie Mae and Freddie Mac are finding it increasingly difficult to bridge the conflicting demands of their private shareholders and federal overseers. Policymakers in Washington have leaned heavily on the mortgage giants this year to play a more aggressive role in propping up the ailing housing market. But after both firms reported bad second-quarter results this week, it is clear they will have trouble becoming the saviors policymakers have envisioned. ...lawmakers haven't dropped their demands that Fannie and Freddie keep pumping money into the mortgage market. House Financial Services Chairman Barney Frank... expressed optimism that they should be able to continue to play a large role in bolstering the housing market. 'Sure, things are tough, but they are still the only game in town,' Frank said..."

Fiscal Watch:

August 13 - Dow Jones (Jeff Bater): "The U.S. government's budget deficit nearly tripled in July, pushed wider partly by failed financial institutions. The Treasury Department said... the government ran a monthly deficit of $102.77bn in July, up 182% from $36.45bn in July 2007. Outlays were $263.26bn last month, up 27% from July 2007's $206.89bn. Elevating spending was a $15bn disbursement by the Federal Deposit Insurance Corp. to cover insured deposits at failed financial institutions... The $263.26bn spending level was a record for the month of July. Government receipts in July were $160.49bn, down 6% from the $170.44 billion recorded the same month a year earlier... ... Year to date, the deficit for fiscal 2008, which ends Sept. 30, totaled $371.44bn, more than double the 157.42bn posted in the same 10-month period a year earlier. Year-to-date outlays were $2.47 trillion, up from the previous period's $2.27 trillion, and revenue was $2.09 trillion, down from $2.12 trillion."

August 11 - Bloomberg (Alison Vekshin): "The failure of IndyMac Bancorp and seven other banks this year may erase as much as 17% of a government insurance fund and raise premiums for all banks, from Franklin National of Minneapolis to Bank of America Corp. The closing of IndyMac in July, the third-biggest U.S. bank failure, may cost the fund $4 billion to $8 billion, in addition to an estimated $1.16 billion for seven closures through Aug. 1. Premiums for deposit insurance will likely rise, FDIC Chairman Sheila Bair said... 'It's going to be a bloody, expensive mess for the banking industry,' said Bert Ely, president of Ely & Co. Inc..."

August 12 - Bloomberg (Henry Goldman and David Mildenberg): "Wall Street's mortgage losses have grown so large that some firms may pay little or no taxes for years, widening New York City and state deficits and challenging their ability to provide services, Mayor Michael Bloomberg said. Some companies are seeking refunds from the city on taxes they prepaid, saying losses have cut their tax liability to zero. The banks pay tax on 110% of earnings in advance as a 'safe harbor,' protecting against penalties for underpayment. 'I think it will be a number of years before Wall Street starts paying taxes again,' the mayor said... 'They will carry forward all of those losses.'"

Speculator Watch:

August 13 - Wall Street Journal (Jay Miller): "Hedge funds had a rough July as bets on rising commodity prices and falling financial stocks failed to pan out, according to research firm Morningstar Inc. The Morningstar 1000 Hedge Fund Index fell 3.07%, its worst monthly performance ever. 'In July, the bet on long commodities and short financials didn't work as well for hedge funds,' said Daniel Farkas, hedge fund analyst for Morningstar... 'It's unusual for hedge funds to underperform stocks in down markets, but hedge funds haven't been able to navigate the credit crunch that started last summer,' Mr. Farkas said."

August 15 - Bloomberg (David Wilson): "Hedge funds had far bigger bets on energy stocks at the start of the third quarter than they did three months earlier and may now regret their investments. The chart of the day shows energy producers accounted for 15.6% of the funds' assets on June 30, up 3.3 percentage points from March 31. The figures are based on data compiled by Bloomberg from regulatory filings. Last quarter's shift was the biggest increase among the 10 main industry groups in the S&P 500 Index."

August 14 - Bloomberg (Mathew Carr): "Billionaire investor Boone Pickens's BP Capital Commodity fund sank 34% in July, hurt by investments in crude oil and natural gas, the New York Post reported... The fund declined about 10% for the year, the newspaper reported. BP Capital manages about $7 billion in assets through two funds..."

August 14 - Wall Street Journal (Cassell Bryan-Low): "The two-year-old hedge fund founded by Jonathan Wood, a former UBS AG trader, is down about 85% from its inception through July... An added sting for investors: They haven't been able to cash out because they agreed not to withdraw money for as long as five years from when they signed up. Those are tight lockup terms, but Mr. Wood was able to command them because of his successful track record as a senior trader at UBS. Mr. Wood's SRM Global Master Fund raised about $3 billion in one of the largest European hedge-fund launches ever when Mr. Wood founded it in September 2006..."

Muni Watch:

August 14 - Bloomberg (Adam L. Cataldo and Michael McDonald): "Public pension funds in the U.S. are increasing bets on high-risk hedge funds and real estate in an attempt to fill deficits in retirement plans and make up for their worst performance in six years. New York Comptroller Thomas DiNapoli is asking lawmakers to increase a cap limiting the amount of so-called alternative investments in the state's Common Retirement Fund, the third-biggest U.S. public pension at $153.9 billion. South Carolina's retirement system adopted a plan in February to invest as much as 45% of its $29 billion in hedge funds, private equity, real estate and other alternatives, from nothing 18 months ago... Public funds, which manage at least $2.45 trillion in assets, are trying to plug deficits and reverse losses that ...Merrill Lynch & Co. says averaged 5.1% in the year ended June 30."

August 13 - Miami Herald (Marc Caputo): "Florida's dwindling state budget could fall about $1 billion deeper into deficit due to a combination of record-high gas prices, the crashing housing market and record job losses in the state."

California Watch:

August 15 - Los Angeles Times (Marc Lifsher): "California's unemployment rate in July rose to 7.3%, its highest level in 12 years as many areas of the economy shed jobs. The state's nonfarm payroll shrunk by 14,900 jobs last month... The unemployment rate increased by three-tenths of a percentage point... and now stands almost two full percentages points higher than the 5.4% it was at a year ago."

August 13 - Financial Times (Matthew Garrahan): "Subprime mortgage defaults are soaring in the northern Californian city of Merced and angry local officials are placing much of the blame for the rout on property speculators from the nearby San Francisco bay area. Subprime mortgages are typically granted to individual homebuyers with tarnished credit histories. But Merced officials say such loans were also granted in large numbers to investors, who used them to buy homes in the city... These investors exploited low 'teaser' rates on the loans to buy homes... The resulting defaults are causing no small measure of hardship in the city... 'During the market runup, not a day went by when I didn't get a call from people in the Bay Area or Los Angeles who wanted to buy in or around Merced,' says Loren Gonella, the owner of Coldwell Banker Gonella Realty."

August 14 - Bloomberg (Michael B. Marois): "A federal receiver charged with improving California's prison health-care system asked a judge to force the state to spend $8 billion on new medical units over five years, a move threatening to widen the budget deficit."

New York Watch:

August 11 - Bloomberg (Michael Quint): "New York Governor David Paterson said he closed this year's $630 million budget deficit through executive orders and presented lawmakers with $1 billion of proposed spending cuts when they return to Albany next week. Falling tax payments from banks, brokerage firms and their workers, which in the past provided 20% of New York's revenue, have widened the budget gap to $6.4 billion from $5 billion for the year beginning April 1, 2009. 'Because of the fact that the budget deficit grew by 28% in just three months for fiscal year 2009-2010, I am pretty sure this deficit will grow even more,' Paterson... said... A hiring freeze and 10% cuts previously ordered at state agencies should close the gap in this year's $85.6 billion budget..."

August 12 - Bloomberg (Dawn Kopecki): "Freddie Mac... told lenders that beginning next month it will no longer buy subprime loans issued in New York state. New York Governor David Paterson last week signed new foreclosure and lending laws that tighten legal protections for borrowers. Freddie won't buy loans dated on or after Sept. 1 that meet the state's new subprime definition..."

August 14 - Bloomberg (Jenny Gross): "New York state must spend more than $50 billion in the next 20 years to meet federal standards for water supply, Reuters reported, citing Governor David Paterson."

Crude Liquidity Watch:

August 13 - BusinessWeek (Steve LeVine): "The sudden war in the Caucasus brought Georgia to heel, reasserted Russia's claim as the dominant force in the region, and dealt a blow to U.S. prestige. But in this part of the world, diplomacy and war are about oil and gas as much as they are about hegemony and the tragic loss of human life. Victory in Georgia now gives Russia the edge in the struggle over access to the Caspian's 35 billion barrels of oil and trillions of cubic feet of gas. The probable losers: the U.S. and those Western oil companies that have bet heavily on the Caspian as one of the few regions where they could still operate with relative freedom. At the core of the struggle is a vast network of actual and planned pipelines for shipping Caspian Sea oil to the world market from countries that were once part of the Soviet empire... But after the mauling Georgia got, 'any chance of a new non-Russian pipeline out of Central Asia and into Europe is pretty much dead,' says Chris Ruppel, an energy analyst at Execution... The risk of building a pipeline through countries vulnerable to the wrath of Russia is just too high."

August 14 - Bloomberg (Peter Robison): "OPEC is pulling in more money from oil sales than the U.S. government is raising from individual taxpayers. ...Organization of Petroleum Exporting Countries' export revenue will surpass what the U.S. raised last year in individual income taxes. The cartel's revenue may reach $1.174 trillion this year... 'This is potentially an empire-ending problem,' said Robert Zubrin, author of 'Energy Victory,' a prescription for achieving U.S. energy independence. 'We're being brought low, and at the same time, someone else is being built up.' Over three years, the 13 OPEC members, including Saudi Arabia, Iran and Venezuela, might bring in $3.5 trillion."

August 10 - Bloomberg (Matthew Brown): "Oman's inflation rate increased for the 22nd month to a record 14% in June on higher food costs, as the U.S. dollar weakened. Food and beverage prices increased an annual 24% in June..."

Dysfunctional Pricing Backdrop:

The divergence between underlying fundamental developments and market trading dynamics became only more striking this week. July Consumer Prices were reported up 5.6% from a year earlier, the largest y-o-y increase since January 1991. July Import Prices were up a record 21.6% y-o-y (data going back to 1982). Despite much worse-than-expected inflation readings, the bond market rallied Thursday. Understandably, the market is rather confident the Fed will ignore inflationary pressures as long as employment trends remain weak. And weak they were. Thursday's report had Continuing Claims for unemployment jumping another 114,000 last week to 3.417 million - the highest level since November 2003. Continuing Claims were up a notable 320,000 in three weeks, increasing the y-t-d gain to 727,000.

The Treasury market is similarly content to disregard what will now be massive ongoing supply of new government debt issues. The federal deficit surged to a record $102.8 billion during July. Spending for the month was up 27.2% y-o-y, pushing fiscal y-t-d spending growth to a positive 8.5%. Receipts were down 5.8% from last July, with fiscal y-t-d Receipts now running 1.0% below a year ago. With two months to go, the fiscal y-t-d deficit has surged to $371bn, up sharply from last year's comparable $157bn.

And despite troubling developments in the Caucasus and heightened geopolitical tensions, the energy and commodities rout ran unabated. Sure, the global economy is slowing. Yet the dramatic price moves being witnessed are indicative of panic liquidations. It is now clear that many within the leveraged speculating community have suffered huge losses over the past few weeks. For a "community" that was already suffering a difficult year, blowups in the popular energy, commodities and short dollar trades were a decisive backbreaker. Huge rallies in heavily shorted stocks and sectors have added further pain. One can now expect major redemptions at quarter and year-ends, a dynamic that likely ensures recent near-chaotic market conditions become the norm for awhile.

I could go on and on with a discussion on deteriorating fundamentals. The economy is rapidly sinking into what will prove a deep and protracted downturn. Mortgage problems are broadening and worsening, ushering in another leg of financial system and housing market tumult. Financial sector spreads widened meaningfully again this week, and it is worth noting that American Express issued 5-year debt this afternoon at an eye-opening 425 bps above Treasuries. Fannie and Freddie debt spreads also widened significantly this week, as did benchmark agency MBS spreads. A severe Credit crunch is now tightening its noose around much of the real economy.

But, for now, fundamentals are not driving market prices. As I wrote last week, markets are about Greed and Fear - and right now Fear Dominates. Those that crowded into the crowded energy and commodities trade are having their heads handed to them. It is also my sense that the scores of long/short funds are likely struggling as well, as many popular longs are performing poorly and popular shorts are in many cases rising spectacularly. The proliferation of "market neutral" and "quant" strategies created too many players all working cleverly to play the same game. Those ranks will be thinned over the coming months.

Today's Wall Street Journal chronicled the pain suffered by one particular hedge fund. Launched in September 2006 by a hot UBS Trader, the fund immediately raised $3.0 billion. Performance has not met expectations. The fund dropped 34% in 2007 and was down 77% y-t-d through July. Worse yet, investors had agreed to up to a five year lockup. So, even the small amount of their remaining investment is inaccessible.

A lot has been written about all the crazy mortgage and derivative products that were peddled during the Bubble. The incredible mania that engulfed the hedge fund community has not yet received it due. It's simply hard to believe the days of new fund managers raising billions with extended lockups isn't coming to an abrupt end. And this is an industry that has for the past few years luxuriated in enormous investment inflows.

While I still read articles noting increased hedge fund investments (see "Muni Watch" above), I can't believe the more sophisticated money is not running or at least considering heading for the exits. At the minimum, the industry appears to have passed a major inflection point, and one should contemplate that acute Ponzi dynamics could easily materialize. As long as the industry was posting strong returns, inflows remained predictably huge. And robust flows ensured that favored positions could be increased and additional leverage employed - self-reinforcing bull market dynamics. These inflows worked to mark up the value of previous investments, as global securities and commodities markets soared. Investors were completely enamored, while "genius" fund managers raked in billions.

This Bubble will not function well in reverse. And I know the argument that most hedge funds are still outperforming the major equities indices. This just doesn't matter much. I expect the entire dynamic of this industry to change now that the majority of funds face "high water marks" (losses that have to be recovered before incentive fees can again be collected). After suffering losses, many managers will be tempted to role the dice with investors' money: "Heads I win and get my head above the high water mark; tails investors lose and I close the fund and enjoy time at the beach." More responsible managers will operate under intense pressure for performance, forced to place bets but with little room for error. This is a particularly grueling endeavor, and you can rest assured that markets won't cooperate.

Such significantly altered trading dynamics - not to mention all the burst global speculative Bubbles - create a backdrop where it becomes extremely difficult for speculators to perform. And resulting wild market volatility significantly compounds the pressure and angst. At the same time, many managers had expected to implement various strategies to play the markets' downside - including shorting, buying put options, writing calls, and certainly playing CDS and various other derivatives. Yet because the Global Leveraged Speculating Community ballooned to unimaginable dimensions, these various systemic "hedges" and bearish speculations all became One Big Crowded Trade. Things are just not going work as expected, a huge problem for investors with grossly inflated expectations.

Wall Street and global speculator community travails are today at the heart of Acute Monetary Disorder. Global pricing mechanisms have turned dysfunctional. Crude oil, the most important commodity in the world, now sees its price fluctuate 30% over a few short weeks - to the upside and then to the downside. Currency values have become similarly unhinged. At the same time, liquidity conditions throughout the global debt markets have turned quite spotty at best. All these factors are working corrosively on the global economy.

The consensus view is that the Fed should maintain today's (grossly inequitable) negative real interest rates indefinitely. This, as the thinking goes, is how the financial sector will repair itself. Everything will then return to normal - eventually. Besides, inflation's won't be much of an issue. I contend that global financial and economic systems will not begin to "normalize" until this massive global pool of speculative finance deflates. Speculators have for some time been the marginal price setters for global securities, energy, commodities and many other asset markets. This is a precarious dynamic, especially considering that large numbers of speculators are impaired and will now be fighting to save their businesses. Things both financial and economic have become hopelessly unstable. And this Dysfunctional Pricing Backdrop has become the major impediment to unavoidable U.S. and global economic adjustment.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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