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September 13, 2008

Too Big to Suffer a Loss
by Doug Noland

For the week, the Dow gained 1.8% (down 13.9% y-t-d) and the S&P500 increased 0.8% (down 14.8%). The Utilities rose 2.6% (down 14.8%), and the Morgan Stanley Consumer index gained 2.2% (down 5.1%). The Transports jumped 3.8% (up 11%), and the Morgan Stanley Cyclical index advanced 3.3% (down 13.2%). The small cap Russell 2000 added 0.2% (down 5.1%), and the S&P400 Mid-Caps increased 0.4% (down 8.1%). The NASDAQ100 was about unchanged (down 15.2%), while the Morgan Stanley High Tech index slipped 0.4% (down 15.6%). The Semiconductors lost 2.9% (down 21.2%). The Street.com Internet Index declined 0.3% (down 11%), while the NASDAQ Telecommunications index gained 1.7% (down 10.2%). The Biotechs gained 1.0% (up 3%). The financial stocks were mixed. With Lehman collapsing, the Broker/Dealers sank 11.6% (down 35.9%). Meanwhile, the Banks gained 3.2% (down 19.9%). With Bullion sinking $37, the HUI Gold index declined 3.6% (down 29.1%).

One-month Treasury bill rates this week sank 28.5 bps to 1.36%, and 3-month yields dropped 27.5 bps to 1.46%. Two-year government yields fell 10 bps to 2.21%. Five-year T-note yields declined 3 bps to 2.95%, while 10-year yields increased 2 bps to 3.73%. Long-bond yields added 2 bps to 4.32%. The 2yr/10yr spread widened 12 to 152 bps. The implied yield on 3-month December '09 Eurodollars dropped 8.5 bps to 3.315%. Benchmark Fannie MBS yields sank 30 bps to 5.32%. The spread between benchmark MBS and 10-year T-notes dropped 33 to 159 bps. The spread on Fannie's 5% 2017 and Freddie's 5% 2017 notes collapsed 30 to 46 bps. The 10-year dollar swap spread fell 6.75 to 61.5. Corporate bond spreads were mostly wider. An index of investment grade bond spreads jumped 6 to 151 bps, and an index of junk bond spreads widened 6 bps to 611 bps.

It was another light week of debt issuance. Investment grade issuance this week included Barrick $1.25bn, Halliburton $1.2bn, Aetna $500 million, Agrium $500 million, Private Export Funding $400 million, and Consumer Energy $350 million.

I saw no junk issuance this week.

Convertible issuance included Mylan $575 million, Tyson Foods $450 million, and Shanda Interactive $175 million.

International dollar debt issuers this week included Oester Kontrolbank $1.75bn.

September 10 - Bloomberg (Lester Pimentel): "Emerging-market bonds fell, pushing yields relative to Treasuries near their widest since June 2005, as slowing economic growth in the U.S. and Europe saps demand for commodities. The extra yield investors demand to own developing nation debt rather than Treasuries widened 17 bps, or 0.17 percentage point, to 3.32 percentage points... according to JPMorgan Chase & Co."

German 10-year bund yields jumped 18 bps to 4.18%. The German DAX equities index rallied 1.7% (down 22.7% y-t-d). Japanese 10-year "JGB" yields rose 7 bps to 1.525%. The Nikkei 225 was little changed (down 20.2% y-t-d). Emerging markets were mostly lower. Brazil's benchmark dollar bond yields jumped 13 bps to 6.02%. Brazil's Bovespa equities index added 0.9% (down 18% y-t-d). The Mexican Bolsa fell 1.2% (down 13.4% y-t-d). Mexico's 10-year $ yields gained 4 bps to 5.62%. Russia's RTS equities index sank 8.7% (down 41.4% y-t-d). India's Sensex equities index fell 3.3%, boosting y-t-d losses to 31%. China's Shanghai Exchange sank 5.6%, with 2008 losses 60.5%.

Freddie Mac 30-year fixed mortgage rates sank a notable 42 bps to 5.93% (down 38bps y-o-y). Fifteen-year fixed rates fell 36 bps to 5.54% (down 43 bps y-o-y), while one-year ARMs increased 6 bps to 5.21% (down 45 bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates this week down 33 bps to 6.93% (up 2bps y-o-y).

Bank Credit dropped $17.4bn (2-wk drop of $43bn) to $9.394 TN (week of 9/3). Bank Credit has expanded only $181bn y-t-d, or 2.8% annualized. Bank Credit posted a 52-week rise of $480bn, or 5.4%. For the week, Securities Credit slipped $1.4bn. Loans & Leases dropped $16.0bn to $6.928 TN (52-wk gain of $405bn, or 6.2%). C&I loans were little changed, with y-t-d growth of 7.2%. Real Estate loans sank $20.9bn (up 1.4% y-t-d). Consumer loans declined $1.2bn, while Securities loans increased $4.6bn. Other loans added $1.7bn.

M2 (narrow) "money" supply fell $5.5bn to $7.716 TN (week of 9/1). Narrow "money" has expanded $253bn y-t-d, or 5.0% annualized, with a y-o-y rise of $346bn, or 4.7%. For the week, Currency added $1.2bn, and Demand & Checkable Deposits jumped$12.8bn. Savings Deposits dropped $21.4bn, while Small Denominated Deposits increased $2.9bn. Retail Money Funds slipped$0.9bn.

Total Money Market Fund assets (from Invest Co Inst) decreased $3.5bn to $3.582 TN, with a y-t-d increase of $469bn, or 21.8% annualized. Money Fund assets have posted a one-year increase of $753bn (26.6%).

Asset-Backed Securities (ABS) issuance picked up somewhat this week. Year-to-date total US ABS issuance of $128bn (tallied by JPMorgan's Christopher Flanagan) is running at 27% of comparable 2007. Home Equity ABS issuance of $303 million compares with 2007's $220bn. Year-to-date CDO issuance of $22bn compares to the year ago $274bn.

Total Commercial Paper outstanding rose another $11.1bn this week to $1.815 TN, with CP up $30bn y-t-d. Asset-backed CP increased $2.6bn last week to $780bn, with 2008 now showing an increase to $7.4bn. Over the past year, total CP has contracted $102bn, or 5.3%.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 9/10) declined $8.5bn to $2.395 TN. "Custody holdings" were up $339bn y-t-d, or 23.2% annualized, and $414bn y-o-y (20.9%). Federal Reserve Credit declined $5.6bn to $888bn. Fed Credit has expanded $14.8bn y-t-d (2.4% annualized) and $31bn y-o-y (3.6%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.211 TN y-o-y, or 21.1%, to $6.945 TN.

Global Credit Market Dislocation Watch:

September 12 - Wall Street Journal (Jon Hilsenrath, David Enrich and Deborah Solomon): "A year into a credit crisis that started with troubled mortgages to sketchy borrowers, the financial system is reeling once again, casting a pall over a widening array of financial institutions just days after history-making efforts by policy makers to contain the problem. With the share prices of Lehman Brothers Holdings Inc., Merrill Lynch & Co. and other financial firms on a roller coaster, the crisis could be entering a critical stage. The Federal Reserve has already slashed interest rates to counteract a deepening credit freeze and instituted its broadest expansion of lending facilities since the Great Depression... Over the weekend, the nation's two main mortgage finance firms -- Fannie Mae and Freddie Mac -- were placed under government control. Federal officials and market players are struggling with the same issues: Why haven't the steps taken so far calmed the system? What can policy makers do next? Should the U.S. government let a big institution fail rather than stage another potentially costly bailout?"

September 9 - Wall Street Journal (James R. Hagerty): "The Fannie Mae and Freddie Mac takeover raises questions about another set of institutions set up by Congress to help finance housing: the 12 regional Federal Home Loan Banks. Like Fannie and Freddie, these banks have long been able to borrow money inexpensively on the bond market because investors assume that the government would rescue them in a crisis. But will the Treasury have to bail out the home-loan banks eventually? And should they benefit from the implied backing of the government? Their regulator plays down the risks. James Lockhart, director of the Federal Housing Finance Agency, or FHFA, which oversees Fannie, Freddie and the home-loan banks, said Sunday that the banks "have performed remarkably well over the last year.' When asked Monday whether he saw any need to overhaul the home-loan banks, he said: 'The structure works.' Fannie, Freddie and the home-loan banks all are known as government-sponsored enterprises, or GSEs -- entities owned by private shareholders but chartered by Congress to perform a public mission. Treasury Secretary Henry Paulson called this GSE model 'flawed' Sunday and said government backing for companies 'needs to be either explicit or nonexistent.' A Treasury spokeswoman said later that Mr. Paulson was referring only to Fannie and Freddie."

September 12 - Bloomberg (Dan Levy): "U.S. foreclosure filings rose to a record in August as falling home prices made it harder to sell or refinance homes to pay off the mortgage, RealtyTrac Inc. said. Owners of 303,879 properties, or one in 416 U.S. households, got a default notice, were warned of a pending auction or foreclosed on last month. That was the most since reporting began in January 2005. Filings increased 27% from a year earlier... 'The chickens have come home to roost,' Jim Croft, founder of the Mortgage Asset Research Institute... 'Real estate inflation bailed out an awful lot of bad loans.' The worst housing slump since the 1930s shows little sign of abating."

September 9 - Dow Jones (David Reilly): "There is a big difference between 'timeout' and 'game over.' Investors should keep that in mind before piling into debt issued by Fannie Mae and Freddie Mac on the back of the government's takeover of the two mortgage giants. As Treasury Secretary Henry Paulson acknowledged Sunday, moves to shore up Fannie and Freddie are temporary. They don't fix the 'inherent conflict of attempting to serve both shareholders and a public mission.' That proved to be a fatal flaw for the firms, whose pursuit of growth to enhance shareholder returns left them ill-prepared to deal with the housing crisis. Until that conflict is resolved, a question mark will linger over Fannie and Freddie. A resolution will lie in the hands of the next president and Congress, who have yet to be elected. That adds political calculus to any investment decision. The resulting uncertainty could act as a brake on any rally in the value of the firms' long-term debt."

September 9 - Wall Street Journal Asia (James T. Areddy): "The U.S. government's decision to nationalize its home-mortgage giants may have given an unintentional endorsement to calls for China's government to rescue its faltering financial markets. In China on Monday, the U.S. Treasury's takeover of Fannie Mae and Freddie Mac was front-page news. China's banks sit on billions of dollars of the agencies' debt securities. Chinese manufacturers, meanwhile, are keen to see the U.S. emerge from a housing crisis that has sapped spending power. China's central bank, the People's Bank of China, praised Washington's move, noting that 'America's financial market influences the stability of the global economic and financial markets.' It added that 'the U.S. government should conscientiously bear the responsibility of safeguarding the stability of the financial market and protect the interests of investors.' But the nationalization move was also fodder for those looking for government relief from China's slowing economic growth and battered stock prices."

September 10 - Bloomberg (John Brinsley): "The U.S.'s stature in global financial markets has diminished because of the housing market collapse and ensuing government intervention and American policy makers need to adopt a softer tone with the rest of the world, former international finance officials said. 'We need to show greater humility in the world,' former U.S. Treasury Undersecretary Tim Adams said... 'We go around the world telling people how to do their business. We need to lead by example, and we have a lot of work to do.'"

September 11 - Dow Jones: "Technical defaults known as events of default have hit 222 CDOs backed by asset-backed securities - that's more than 30% of all ABS CDO issuance since 2000, Citi analysts write in a report. Of ABS CDO from 2007, 68% have triggered events of default, and 43% of CDOs from 2006 have. In the pipeline to be liquidated are 19 deals valued over $21B."

September 12 - Financial Times (Stacy-Marie Ishmael): "The volume of equities and derivatives traded on global exchanges declined sharply in August as hedge funds and investment banks scaled back operations, raising concerns that reduced market liquidity might be exacerbating price swings. The value of equities traded on global exchanges last month fell 37% compared with the same period a year ago, while derivative volumes fell 21%, according to Citigroup..."

September 11 - Bloomberg (Alex Nicholson and Maria Levitov): "Russia must do more to pump extra funds into its financial markets as investors continued to pull money out of the country, crimping liquidity and pushing the stock market down, President Dmitry Medvedev said."

Global Inflation Turmoil Watch:

September 12 - Bloomberg (Farhan Sharif): "Pakistan's inflation accelerated to a three-decade high in August... Consumer prices in South Asia's second-largest economy jumped 25.33% from a year earlier..."

September 10 - Bloomberg (Abdel Latif Wahba and Mahmoud Kassem): "Egyptian inflation rose to an annual 23.6% in August, the highest since 1992, putting pressure on the central bank to raise interest rates for a sixth time this year."

Currency Watch:

It was one wild ride, yet the dollar index ended the week about unchanged at 78.97. For the week on the upside, the British pound increased 2.1%, the Australian dollar 0.9%, the Danish krone 0.7%, the Euro 0.7%, the Singapore dollar 0.4%, the Japanese yen 0.4%, and the Canadian dollar 0.3%. For the week on the downside, the Brazilian real declined 2.5%, the South Korean won 2.5%, the South African rand 1.0%, the Taiwanese dollar 0.9%, the Mexican peso 0.9%, and the Norwegian krone 0.7%.

Commodities Watch:

Gold sank 4.7% to $766 and Silver 11.2% to $10.95. September Crude declined $5.35 to $100.88. September Gasoline rose 3.0% (up 11.7% y-t-d), while September Natural Gas dipped 0.6% (down 1.1% y-t-d). December Copper rallied 3.0%. September Wheat declined 3.6%, while December Corn gained 2.7%. The CRB index declined 2.1% (up 0.4% y-t-d). The Goldman Sachs Commodities Index (GSCI) fell 2.6% (up 4.9 y-t-d and 21.7% y-o-y).

China Watch:

September 12 - Bloomberg (Kevin Hamlin and Nipa Piboontanasawat): "China's industrial production grew at the slowest pace in six years on weaker export demand and factory shutdowns for the Olympics, increasing the likelihood the government will stimulate the economy. Output rose 12.8% in August from a year earlier... after gaining 14.7% in July."

September 10 - Bloomberg (Nipa Piboontanasawat and Li Yanping): "China's inflation weakened to the slowest pace since June 2007 and export growth cooled, adding to speculation the government will cut taxes and ease loan restrictions to spur the world's fourth-largest economy. Consumer prices rose 4.9% in August from a year earlier, less than economists estimated, after gaining 6.3% in July... Exports rose 21.1% in August, down from July's 26.9% gain, the Customs Bureau said."

September 10 - Bloomberg (Li Yanping): "Foreign direct investment in China climbed 41.6% in the first eight months from a year earlier, adding to the flood of cash that could stoke a rebound in inflation in the world's fastest-growing major economy. Spending by overseas companies increased to $67.7 billion..."

September 12 - Bloomberg (Nipa Piboontanasawat): "China's retail sales grew at close to the fastest pace in at least nine years as rising incomes encouraged consumer spending. Retail sales rose 23.2% in August from a year earlier to 876.8 billion yuan ($128bn)..."

Japan Watch:

September 12 - Bloomberg (Jason Clenfield): "Japan's economy contracted more than the government initially estimated last quarter after figures showed businesses cut spending. Gross domestic product shrank an annualized 3% in the three months ended June 30... more than the 2.4% drop reported last month."

September 8 - Bloomberg (Kathleen Chu): "The number of Japanese real estate companies filing for bankruptcy protection surged 23.5% in August from a year earlier as banks choke off loans to the industry."

Asia Bubble Watch:

September 8 - Bloomberg (Janet Ong): "Taiwan's export growth unexpectedly accelerated in August on rising sales to China. Overseas shipments increased 18.4% from a year earlier..."

September 11 - Bloomberg (Chia-Peck Wong): "Vietnam's banking sector is the 'most vulnerable' to an economic slowdown compared with its Asian peers, Standard & Poor's analysts said today. As the Southeast Asian country's banking sector is still in the 'initial stages of development, it does not have the resistance to go through' the current turbulence unscathed, Ritesh Maheshwari, a... S&P analyst said..."

Latin America Watch:

September 10 - Bloomberg (Joshua Goodman and Andre Soliani): "Brazil's central bank raised its benchmark interest rate to the highest in almost two years in a bid to cool accelerating economic growth that's stoking inflation... Policy makers led by Henrique Meirelles voted 5-3, without a bias, to increase the so-called Selic rate to 13.75% from 13%..."

September 9 - Associated Press: "Mexican inflation has hit its highest rate in five years. The Bank of Mexico says annual inflation reached 5.57% in August. That's the highest point since March 2003, when inflation was at 5.64%."

September 9 - Bloomberg (Matthew Walter): "Venezuela's annual inflation rate accelerated for the eleventh consecutive month, driven by rising food costs, even after the government took steps to drain liquidity and curb price gains in the oil exporting economy. Consumer prices measured by the central bank's benchmark Caracas index climbed 34.5% in August from a year earlier..."

Unbalanced Global Economy Watch:

September 10 - Bloomberg (Brian Swint): "The U.K. economy is contracting for the first time in at least a decade, the National Institute for Economic and Social Research said. Gross domestic product dropped 0.2% in the June to August period and fell 0.1% in the three months through July... The May to July estimate... was the first decline since Niesr started its calculation in April 1996."

September 9 - Bloomberg (Svenja O'Donnell): "U.K. house prices dropped in August as the squeeze on mortgage lending pushed down sales to a record low, the Royal Institution of Chartered Surveyors said. The number of real-estate agents and surveyors saying prices fell exceeded those reporting gains by 81 percentage points, compared with 83 percentage points in July... Average sales per respondent in the past three months fell to 12.7, the least since the survey began in 1978. 'A lack of mortgage liquidity is the key issue which is keeping the housing market from showing any real sign of recovery,' Jeremy Leaf, a spokesman for RICS, said... 'While money is scarce, many will continue to be denied the next step on the property ladder.'"

September 9 - Bloomberg (Johan Carlstrom): "Swedish inflation accelerated in August, supporting the central bank's case for rates to remain on hold for the rest of the year. The headline inflation rate rose to 4.3% from a revised 4.1% in July..."

September 10 - Bloomberg (Christian Wienberg): "Denmark's inflation rate unexpectedly rose to a new 18-year high in August, adding to concern that workers will demand higher pay to compensate for the rising cost of living. Inflation accelerated to 4.3% from 4% in July..."

September 10 - Bloomberg (Maria Levitov): "Russia's economy expanded at a slower pace in the second quarter as lower investment and the strong ruble hurt domestic producers. Gross domestic product grew 7.5%, compared with 8.5% in the previous three-month period..."

September 10 - Bloomberg (Steve Bryant): "Turkey's economy grew at the slowest pace since the country emerged from a recession six years ago as higher interest rates and the threat of political instability hurt consumer spending. Gross domestic product growth slowed to 1.9% from a revised 6.7% in the previous quarter..."

September 9 - Bloomberg (Tracy Withers): "Sales of New Zealand houses fell to a 26-year low in August as interest rates close to a record curtailed demand for property. The number of homes sold dropped 34 percent to 4,220 in August from 6,394 a year earlier... The median house price dropped 5.7%."

Bursting Bubble Economy Watch:

September 12 - Bloomberg (Dan Levy and Bob Ivry): "For Dean Nessen, the choice of a mortgage was easy. By agreeing to pay only interest for three years, the self-employed salesman didn't have to show proof of income and landed a rate of 6.25%. Now, four years later, Nessen's industrial coatings business has gone belly up and his rate has jumped to 10.6%. He can't afford the payments... Homeowners lured by low introductory rates to Alt-A mortgages, which typically require little or no proof of a borrower's income, may fuel the next wave of foreclosures... Almost 16% of securitized Alt-A loans issued since January 2006 are at least 60 days late... Defaults will accelerate next year and continue through 2011 as these loans hit their three- and five-year reset periods... 'Alt-A will be another headache,' said T.J. Lim, the... co-head of markets at Unicredit Group. 'I would be very worried about anything issued in the last half of 2006 and the first half of 2007.'"

September 9 - Wall Street Journal (Greg Hitt and Nick Timiraos): "The housing crisis appears likely to be the next president's No. 1 domestic priority, sapping time and taxpayer dollars from some of the other initiatives that candidates John McCain and Barack Obama have proposed. The Bush administration pledged to provide as much as $200 billion to help cover losses at Fannie Mae and Freddie Mac in the government's takeover of the troubled mortgage companies. The takeover was intended to shore up the nation's housing sector and reassure financial markets. But the plan also expands taxpayers' liability and could widen the federal budget deficit, which is projected at more than $400 billion for the 2008 fiscal year ending Sept. 30. The nonpartisan Congressional Budget Office is expected to release an update Tuesday on the outlook for the current and next fiscal years. Congressional aides on both sides of the aisle were bracing for dismal numbers, with the 2009 deficit projected -- before the takeover -- to approach $500 billion."

September 9 - Dow Jones (Andrea Coombes): "Unless you work in the oil, gas or related mining industries, the job market is unlikely to look brighter in the fourth quarter, and even retailers are glum about hiring for the upcoming holiday season, according to the latest Manpower Employment Outlook Survey. The... firm's quarterly survey of hiring plans found that a net 9% of firms expect to hire in the fourth quarter, down from 12% in the previous quarter, and 18% for the fourth quarter a year ago. This fourth-quarter outlook is the tenth consecutive quarter of declining employer sentiment in the survey - the longest such retreat in more than 20 years Manpower's seasonally adjusted net-employment numbers, based on a survey of 14,000 U.S. companies, measure the percentage of firms planning to hire minus those intending layoffs."

September 10 - Wall Street Journal (Jacqueline Palank): "Chapter 11 bankruptcy filings skyrocketed in August after holding fairly steady all year, an increase experts say may have been boosted by seasonal and retail businesses. Last month, 1,082 businesses and some individuals filed for Chapter 11 protection, a 38% increase from the 786 new Chapter 11 filings in July... The August increase marks a significant climb from numbers that have hovered in the range of 700 to 790 throughout the year..."

September 11 - Bloomberg (Timothy R. Homan): "The U.S. trade deficit widened more than forecast in July as oil imports soared to a record, overshadowing gains in exports. The gap grew 5.7% to $62.2 billion, the largest in 16 months, from a revised $58.8 billion in June that was bigger than previously estimated... Total imports and exports were the highest ever."

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

September 10 - Dow Jones (Romy Varghese): "The U.S. government takeover of Fannie Mae and Freddie Mac has triggered a technical default on insurance-like contracts investors used to hedge risk on the mortgage finance giants' $1.6 trillion of outstanding debt. This marks one of the largest so-called 'credit events' to hit the $62 trillion market for credit default swaps in recent years, though market participants expect the fallout on the broader market to be limited. While the debt of Fannie and Freddie now enjoys the explicit backing of the U.S. government, the bailout announced Sunday means existing credit default swaps must be settled. 'We are in many aspects on new ground,' said Vince Breitenbach, managing director and head of U.S. credit research at Barclays Capital in New York. On Monday, the International Swaps and Derivatives Association, which represents derivatives participants, said it will create a protocol to facilitate the settlement of credit default swap trades on Fannie Mae and Freddie Mac."

September 9 - Bloomberg (Neil Unmack): "Moody's... cut its performance outlook for collateralized debt obligations that package company debt on expectations slowing economic growth will trigger an increase in defaults. Moody's lowered forecasts on CDOs backed by U.S. and European leveraged buyout debt, company loans and credit-default swaps to 'negative' from 'stable/negative,' the... firm said..."

Real Estate Bust Watch:

September 9 - Wall Street Journal (Markus Balser): "With Florida awash in tens of thousands of empty or unfinished condominiums, many investors there are turning to the courts in an effort to cancel their contracts and recoup their deposits. So far, they haven't had much luck. Condo buyers in hard-hit markets across the country have been scouring their contracts for loopholes and flaws that would allow them to back out. Investors in Florida, where many were looking to flip their condos for a quick profit in a rising market, have been particularly aggressive in using the courts. And that's no surprise, given that the condo market there is one of the worst in the country, with average condo prices down 22% since the market peaked in 2005... and they're still falling. Yet a series of recent legal decisions in the Florida courts indicate that it won't be as easy as buyers might hope to get out of these deals. The bottom line: Unless it's a bona fide contract dispute, an investor's chances of winning appear to be slim."

GSE Watch:

September 9 - Bloomberg (Dawn Kopecki): "Treasury officials found Fannie Mae and Freddie Mac were 'playing games with their accounting' to meet reserve requirements, prompting the government to seize control of the companies, U.S. Senator Richard Shelby said. 'They found out they had a house of cards,' Shelby of Alabama, the ranking Republican on the Senate Banking Committee, said in a telephone interview. Shelby said Treasury officials told him in a briefing today that ``once they got someone looking closely at Fannie and Freddie's books, they realized there just wasn't adequate capital there.' Treasury Secretary Henry Paulson and the Federal Housing Finance Agency seized control of Fannie and Freddie less than a month after FHFA Director James Lockhart, whose job is to oversee the companies, declared them 'adequately capitalized.' Morgan Stanley was brought in to help the Treasury assess the companies' financial condition along with examiners from the Federal Reserve and the Office of the Comptroller of the Currency. 'We concluded that the capital of these institutions was too low relative to their exposure,' Dallas Federal Reserve President Richard Fisher said... Further, 'that capital in and of itself was of low quality.'"

Speculator Watch:

September 9 - Wall Street Journal (Donna Kardos): "A survey of the largest U.S. hedge-fund firms showed that 35% of them lost assets in the first half of the year, putting the growth rate at 4.3%, the lowest in six years. Data provider Hedge Fund Research recorded a 0.75% fall in value for its HFRI Fund Weighted Composite Index, the benchmark that reflects the average performance of all hedge funds in its database. The decline is the second time hedge funds lost investors' money in the first half of a year since Hedge Fund Research started gathering data on the industry in 1990."

September 10 - Dow Jones (Digby Larner): "Hedge fund manager RAB Capital PLC said... that investors in its RAB Special Situations strategy will be asked to lock in their cash for three years in return for lower management and performance fees. RAB said the plan affects investors in two vehicles that feed investment into its Special Situations strategy... If investors reject the proposal the funds face liquidation, RAB said. The move is intended to stanch the loss of liquid assets from the funds. In August, the Special Situations strategy fell by an estimated 22% over the month, taking the year-to-date estimated decline to 48%."

September 10 - Bloomberg (Saijel Kishan and Stewart Bailey): "RK Capital Management LLP, the metals hedge-fund firm co-founded by Michael Farmer, lost as much as 30% last month amid falling cooper and aluminum prices, according to an investor with the firm."

September 8 - Bloomberg (Oshrat Carmiel): "Camulos Capital LP, a $2.5 billion hedge fund specializing in corporate-credit investments, offered to cut its management fees if investors agree to keep their money with the firm for another year, the Wall Street Journal reported... Camulos investors asked to pull almost $350 million from the firm's biggest funds after the investments lost about 20% through early this month..."

September 10 - Bloomberg (William Mauldin): "Russian stocks may continue to decline after falling the most in two years yesterday because investment fund redemptions and margin calls are 'dictating the market,' JPMorgan Chase & Co. said. 'We see little support for Russian equities today,' JPMorgan strategist Peter Westin in Moscow said in a note to investors. 'Metals and mining and financial stocks may be especially vulnerable.'"

Fiscal Watch:

September 12 - New York Times (Louise Story): "Making millions — or even a few billion — by managing a hedge fund has been a running dream on Wall Street in recent years. But suddenly even the masters of this $2 trillion universe are falling on hard times, at least by their own gilded standards. Hedge funds...are supposed to make money whether markets go up or down. But many of them are being swept up in the turmoil in the financial world. The funds' investment returns are sinking, and so are those big paydays for their managers, whose riches have helped redefine modern notions of wealth and helped drive up the price of everything from Picassos to Manhattan penthouses.

Several big funds have faltered in recent weeks, some of them spectacularly so. While many funds are still flying high, the average hedge fund has lost more than 4% this year, putting the industry on course for its worst year on record. The dimming fortunes of the industry have implications far beyond the rarefied world of hedge funds. Over the last decade, the size of this industry grew fivefold, as public pension funds, corporate pension funds and university endowments poured billions of dollars into these vehicles, in hopes of market-beating returns."

September 10 - Wall Street Journal (Patrick Yoest): "The Congressional Budget Office said the U.S. budget deficit for fiscal 2008 -- $407 billion -- will be more than double the deficit for 2007... 'The figures make it challenging to avoid playing the dismal economist,' said CBO director Peter Orszag... The agency foresees an increase to $438 billion by fiscal 2009, which begins Oct. 1, with the government takeover of Fannie Mae and Freddie Mac further complicating budget projections. The fiscal 2008 budget deficit will rise to 2.9% of gross domestic product this year, according to the agency, up from 1.2% of GDP in 2007. The fiscal 2007 deficit was $161 billion. 'The budget deficit has risen substantially over the past year,' Mr. Orszag said. 'And according to CBO's updated economic forecast, the economy is likely to experience at least several more months of weakness.'"

September 10 - MarketNew International (John Shaw): "Congressional Budget Office Director Peter Orszag said... that if all of President Bush's 2001 and 2003 tax cuts are extended and the alternative minimum tax is patched each year as well as maintaining current levels of federal spending, the U.S. could generate more than $7 trillion in cumulative deficits over the next decade. 'The nation is on an unsustainable long term fiscal course,' Orszag said... Orszag noted that there has been 'a very significant increase' in the federal budget deficit as it rose from $161 billion in FY'07 to a projected $407 billion in FY'08. Orszag said that it is not difficult to project a deficit of more than $500 billion in FY'09... The CBO believes that it is important to incorporate the operations and activities of Fannie Mae and Freddie Mac into federal budget calculations, Orszag said... Orszag said that Fannie and Freddie now should be 'directly incorporated into the federal budget." But added that 'there are many thorny technical issues' in doing so."

September 10 - Bloomberg (Shamim Adam): "The U.S. may post a $565 billion budget deficit next year, and risks of an even wider shortfall are on the ``high side' amid the possibility of more economic stimulus packages and rescues of financial institutions, Goldman Sachs Group Inc. said. The estimate is $100 billion more than Goldman's previous prediction for the year starting Oct. 1 and exceeds the Congressional Budget Office's forecast for a $438 billion shortfall, Edward McKelvey and Alec Phillips wrote in a note published yesterday. The deficit will be about $560 billion in 2010, the report said. 'The budget outlook is subject to even more uncertainty than usual because of current economic and financial conditions,' they said. ``Potential costs associated with a second round of stimulus if enacted, the takeover of government sponsored enterprises and other financial issues such as bank failures, and possible post-election changes in fiscal policy, impart a significant upside risk to our estimates for 2009.'"

Muni Watch:

September 9 - Bloomberg (Jeremy R. Cooke): "The Los Angeles Community College District led U.S. state and local government borrowers today, part of record municipal issuance this year, as tax-exempt bonds gained, buoyed by a two-day rally in Treasuries. The Los Angeles district offered about $650 million of bonds to build and renovate facilities around the nation's largest system of two-year colleges. The North Texas Tollway Authority and New York's State Dormitory Authority also were among the largest municipal borrowers today. Municipal bond sales, driven by states and cities refinancing auction-rate debt and raising funds for capital spending, totaled $296.7 billion in 2008 through last week, according to a Merrill Lynch & Co. report... That's almost 2% higher than the comparable period in 2007, when the full-year record of $430 billion was set."

New York Watch:

September 9 - Bloomberg (Michael Quint): "The collapse of the market for auction-rate bonds put New York state in the same position as millions of homeowners whose adjustable-rate mortgages reset: It wanted to refinance. The state had $4 billion in debt with interest rates, set in periodic auctions, that soared as high as 14.2% after bidders vanished in February. That was more than triple the January average."

Crude Liquidity Watch:

September 10 - Bloomberg (Matthew Brown and Abigail Moses): "The cost of protecting Dubai government bonds from default doubled in the past three months on concern the emirate will be unable to maintain the borrowing that's driven its real-estate boom. Credit-default swaps protecting Dubai debt for five years traded at 220 bps, CMA Datavision prices show, up from 110 at the beginning of June..."

To Big to Suffer a Loss:

This will be another captivating weekend, with focus on both Ike and Lehman. The experts are anticipating that Ike may be the worst hurricane to hit Texas in 50 years. Today's financial storm is a once-in-a-lifetime, ongoing event. Indeed, it is my sense this evening that this financial maelstrom has now reached a new erratic and highly uncertain stage. That the Fed would respond to the collapsing U.S. Credit Bubble with a string of rapid rate cuts was no surprise. That the Fed would step up and bail out Bear Stearns, while at the same time providing liquidity facilities to the Wall Street firms, was similarly predictable. It was like clockwork when the GSEs responded to market tumult and the mortgage collapse by heedlessly expanding their obligations. And while I was surprised that the likes of OFHEO's Lockhart and the gents at Pimco proved key enablers for the GSE's last gasp of recklessness, that the federal government would be forced to step up and nationalize Fannie and Freddie should have been anything but a bombshell development. Only the timing of the "bazooka" blast was up in the air.

Washington has certainly brought out the big guns - resorting to them so early in the crisis but to alarmingly limited avail. Negative real interest rates and even unprecedented bailouts do little to address the deep structural deficiencies that have developed over many years. Sustaining inflated U.S. asset markets requires massive ongoing growth in Credit and speculative trading. The deeply maladjusted U.S. "services" Bubble economy is sustained only through ongoing Credit excess. To be sure, the heart of today's predicament lies in the reality that a heavily impaired U.S. financial sector is simply incapable of partaking in the degree of Credit excess required to sustain inflated assets prices, incomes, corporate profits, government receipts and much needed (restructuring-related) investment spending. The problem is systemic. Bailouts and other government measures have minimal impact because they are not inciting heightened Credit expansion.

And while the media directed its attention to Lehman, the pricing of AIG Credit Default Swaps (CDS) exploded this week. This is a company with a Trillion dollar balance sheet and enormous exposure to the CDS market and other derivatives. And although its balance sheet is only about a third the size of AIG's, Washington Mutual also saw its CDS blow out. And while most holders of Fannie and Freddie obligations have come out of the GSE fiasco unscathed (or better), one can see how this crisis going forward will see more pain meted out to the corporate bondholder - not just the poor lowly equity owner. Perhaps the prospect of Lehman debt holders suffering losses has pushed the acutely vulnerable CDS market to the edge.

The last thing the crippled leveraged speculating community needs right now is dislocation in the CDS marketplace. Again, the attention this week was on Lehman, while I believe a much more unwieldy facet of today's crisis mounts with the bursting of the historic hedge fund Bubble. Perhaps Sunday we'll read news of BofA acquiring Lehman - and perhaps the markets will rally big on such news. But such a transaction would have little if any impact on crisis dynamics that have engulfed the leveraged speculating community. The various markets - global equities, real estate, mortgages, energy and commodities, currencies, CDS and risk assets generally - have all become an absolute and unmitigated mess. Money is being lost in waves; scores of favorite trades are being unwound; redemptions are gathering pace; and the ugly side of Ponzi Finance Dynamics has taken firm control.

Importantly, there is today no magical cure - no government bailout - that is going to rejuvenate robust speculator returns. The Credit Bubble burst, and now the speculator Bubble is bursting. As we have been witnessing of late, stock market rallies tend to show their greatest force in the sectors where the speculators are short. Meanwhile, stock market declines tend to see the favored sectors lead on the downside. Worse yet, astonishing volatility throughout the markets has created a backdrop where it has become too easy to "get your face ripped off." Repeated government interventions have only exacerbated market instability and vulnerability.

I find it rather odd that Secretary Paulson and the Administration were keen to boast that Fannie and Freddie shareholders would not benefit at the expense of the U.S. taxpayer. Yet it's not as if there were moral hazard issues that had incentivized these shareholders into risky speculative activities at the expense of systemic stability. On the other hand, moral hazard played a fundamental role in Pimco's and others' speculative endeavors in agency debt and MBS obligations (enabling the GSEs' reckless expansion of risk). And, what do you know, The Enablers came out the big winners.

There's a lot of talk these days about institutions that are Too Big to Fail. But this misses the more important point. The heart of the problem is systemic throughout the Credit system, and I'll refer to it as Too Big to Suffer a Loss. The entire financial system would have come unglued if agency debt and MBS holders suffered losses - losses that could have triggered another round of speculative deleveraging - that could have triggered outflows from "bond" funds - that could have triggered losses in "money" funds and/or a flight from the dollar.

"Moneyness of Credit" remains an invaluable analytical concept. Despite acute vulnerability, the U.S. Credit system - hence the American economy - has resisted implosion specifically because the heart of the monetary system has retained its "Moneyness." Indeed, nationalizing Fannie and Freddie was seen as necessary to retain confidence in the core of contemporary "money" - agency obligations, "repos" and money fund assets. This highly inflated supply of "money" has become so large as to almost on its own shoulder the entire U.S. (global?) financial system and economy. "Money" has become Too Big and Consequential to Suffer a Loss.

Pimco and others savvy players appreciated this dynamic and exploited it for all it was worth. Ironically, with all the losses being suffered throughout the markets, the moral hazard issue has never been as precarious. The government "printing press" now includes agency debt and MBS. The incentives to enable the continued rampant inflation of contemporary "money" have never been stronger, with the consequences of these obligations losing their "Moneyness" never even remotely as consequential. Perhaps Treasury and the Administration will stick to their word and not provide taxpayer funds to save Lehman and others. Yet why do I feel the next step of government intervention will be to bolster the "repo" market. Looks like the days of easy government interventions have run their course.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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