Credit Market Dislocation

By: Doug Noland | Fri, Aug 3, 2007
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For the week, the Dow dipped only 0.6% (up 5.8% y-t-d), but more intense selling saw the S&P500 was hit for 1.8% (up 1.0%). The Transports were slammed for 3.2% (up 6.9%), while the Utilities managed a 0.2% rise (up 1.6%). The Morgan Stanley Cyclical index declined 0.9% (up 13.8%), and the Morgan Stanley Consumer index dipped 0.2% (up 0.8%). The broader market was under heavier selling pressure. The small cap Russell 2000 sank 2.9% (down 4.1% y-t-d), and the S&P400 Mid-Cap index fell 2.1% (up 4.5%). The NASDAQ100 dropped 1.9% (up 9.2%), and the Morgan Stanley High Tech index sank 2.5% (up 8.7%). The Semiconductors fell 2.9% (up 4.2%). The Street.com Internet Index declined 1.5% (up 7.5%), and the NASDAQ Telecommunications index dipped 0.4% (up 11.5%). The Biotechs dropped 2.5% (down 0.7%). Financial stocks were under heavy selling pressure. The Broker/Dealers were clobbered for 7.6% (down 11.3%), and the Banks dropped 3.5% (down 13.3%). With Bullion gaining $11.80, the HUI Gold index added 0.5% (up 0.4%).

Two-year U.S. government yields this week declined 7 bps to 4.42%. Five-year yields fell 8 bps to 4.48%. Ten-year Treasury yields dropped 9 bps to 4.68%. Long-bond yields ended the week 7 bps lower at 4.86%. The 2yr/10yr spread ended the week at a positive 26 bps. The implied yield on 3-month December '07 Eurodollars dropped 11.5 bps to 4.985%. Benchmark Fannie Mae MBS yields fell 12 bps to 6.10%, this week only partially recovering from last week's significant widening versus Treasuries. The spread on Fannie's 5% 2017 note widened 2 to 65, and the spread on Freddie's 5% 2017 note widened one to 65. The 10-year dollar swap spread declined one to 74.65. Corporate bond spreads widened further, with the spread on a junk index this week widening 50 bps.

Investment grade debt issuers were limited to GE Capital $2.0bn and Coca-Cola Enterprises $450 million.

August 2 - Bloomberg (Fabio Alves): "Investors pulled money out of high-yield corporate bond funds for an eighth straight week, according to AMG... High-yield bond funds reported net outflows of $2.7 billion in the week ended Aug. 1..."

No junk issuance this week.

Convert issuers included Horizon Lines $300 million.

No international dollar bond issuance this week.

German 10-year bund yields were little changed at 4.32%, and the DAX equities index down 0.2% (up 12.7% y-t-d). Japanese 10-year "JGB" yields declined one basis point to 1.77%. The Nikkei 225 fell 1.8% (down 1.4% y-t-d). Emerging debt and equity market trading has turned highly unstable. Brazil's benchmark dollar bond yields sank 31 bps this week to 6.16%. Despite wild volatility, Brazil's Bovespa equities index closed the week down only 0.1% (up 18.8% y-t-d). The Mexican Bolsa dropped 1.9% (up 12.2% y-t-d). Mexico's 10-year $ yields dropped 16 bps to 5.88%. Russia's RTS equities index added 0.2% (up 2.5% y-t-d). India's Sensex equities index declined 0.6% (up 9.8% y-t-d). China's Shanghai Composite index ended the week 5% higher to a new record high (up 70.5% y-t-d and 185% over the past year).

Freddie Mac posted 30-year fixed mortgage rates dipped one basis point this past week to 6.68% (up 5bps y-o-y). Fifteen-year fixed rates fell 5 bps to 6.32% (up 5bps y-o-y). One-year adjustable rates dropped 10 bps to 5.59% (down 10 bps y-o-y). The Mortgage Bankers Association Purchase Applications Index declined 1.8% this week to a 13-wk low. Purchase Applications were up 9.8% from one year ago, with dollar volume 15.5% higher. Refi applications increased 1.8% for the week, and dollar volume was up 24.6% from a year earlier. The average new Purchase mortgage was little changed at $234,300 (up 5.2% y-o-y), while the average ARM slipped to $393,500 (up 13.1% y-o-y).

Bank Credit added $2.8bn (week of 7/25) to $8.646 TN, after gaining $24.2bn the prior week. For the week, Securities Credit declined $4.5bn. Loans & Leases gained $7.3bn to $6.332 TN. C&I loans dipped $0.5bn, while Real Estate loans jumped $10bn. Consumer loans declined $1.4bn. Securities loans fell $6.2bn, while Other loans increased $5.5bn. On the liability side, (previous M3) Large Time Deposits dropped $10.4bn.

M2 (narrow) "money" increased $8.1bn to $7.273 TN (week of 7/23). Narrow "money" has expanded $229bn y-t-d, or 5.6% annualized, and $428bn, or 6.3%, over the past year. For the week, Currency rose $1.7bn, while Demand & Checkable Deposits declined $11.9bn. Savings Deposits jumped $19bn, while Small Denominated Deposits dipped $0.2bn. Retail Money Fund assets slipped $0.5bn.

Total Money Market Fund Assets (from Invest. Co Inst) surged $23bn last week to a record $2.607 TN. Money Fund Assets have increased $225bn y-t-d, a 15.8% rate, and $436bn over 52 weeks, or 20.1%.

Total Commercial Paper declined $11.9bn last week to $2.213 TN, with a y-t-d gain of $238bn (20.3% annualized). CP has increased $423bn, or 23.6%, over the past 52 weeks.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 7/18) rose $7.0bn to a record $2.010 TN. "Custody holdings" were up $258bn y-t-d (24.7% annualized) and $356bn during the past year, or 21.6%. Federal Reserve Credit last week jumped $7.4bn to $857.6bn. Fed Credit has expanded $5.4bn y-t-d, with one-year growth of $24.6bn (3.0%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $846bn y-t-d (30% annualized) and $1.095 TN y-o-y (24%) to a record $5.657 TN.

August 2 - Bloomberg (Kim Kyoungwha): "South Korea's foreign-exchange reserves, the world's fifth largest, rose last month as the central bank earned more from interest payments. The reserves increased to $254.8 billion in July, a $4.1 billion gain from the previous month..."

August 1 - Dow Jones: "Brazil's foreign currency reserves grew by $8.8 billion in July as the central bank continued actively buying U.S. dollars... Brazilian foreign reserves reached $155.9 billion on July 31... At the end of the first seven months, reserves were up 81.6% when compared with the end of last year. The country's reserves were $85.839 billion at the end of 2006."

Currency Watch:

The spot dollar index dropped 1% to 80.117. On the upside, the Norwegian krone gained 1.5%, the Swiss franc 1.5%, the Euro 1.0%, the Danish krone 1.0%, and the British pound 0.8%. On the downside, the New Zealand dollar fell 0.6%, the South African rand 0.3%, and the Brazilian real 0.3%.

Commodities Watch

August 1 - Financial Times (Javier Blas): "Tin yesterday rose to an all-time high, propelled by supply concerns and robust speculative buying. The metal, one of the most illiquid contracts on the London Metal Exchange, has risen 42% since January..."

For the week, Gold rose 1.8% to $673 and Silver 3.5% to $13.16. Copper rose 2.5%. September crude declined $1.98 to $75.04. September gasoline declined 1.3%, and September Natural Gas dropped 2.6%. For the week, the CRB index slipped 0.5% (up 3.6% y-t-d), and the Goldman Sachs Commodities Index (GSCI) declined 1.3% (up 16% y-t-d).

Japan Watch:

August 2 - Bloomberg (Lily Nonomiya and Masahiro Hidaka): "Japanese companies may increase spending at the fastest pace in 17 years, the Development Bank of Japan said, adding to evidence that the central bank may raise interest rates as soon as this month. Companies plan to increase spending 11% in the year ending March 31..."

August 1 - Bloomberg (Kathleen Chu): "Japanese land prices rose 8.6% last year, more than nine times faster than in 2005, when a 16-year property slump ended because of a rebound in the world's second-largest economy. The average price of land jumped to 126,000 yen ($1,063) per square meter..."

China Watch:

August 2 - Bloomberg (Zhao Yidi): "China's central bank said will set up a deposit insurance plan to guarantee savings and protect depositors from bankrupt banks, seeking to instill public confidence in the country's financial system. The People's Bank of China today signed an accord with the U.S. Federal Deposit Insurance Corp. to cooperate on financial services and deposit insurance, according to a statement. China's central bank, custodian of the world's largest foreign-currency reserves, wants to shield the country's 36.9 trillion yuan ($4.87 trillion) of local-currency deposits from bankrupt banks and maintain public confidence in the financial industry. The assurance plan comes amid increasing calls by government officials for banks to refrain from lending money to stock market punters and real estate speculators."

July 31 - Bloomberg (Li Yanping): "China's inflation may accelerate in the third quarter of this year to reach 4.8%, the China Business Times reported, citing Song Guoqing, an economist at Peking University's China Center for Economic Research."

July 30 - Bloomberg (Nipa Piboontanasawat): "China ordered banks to set aside larger reserves for the sixth time this year to curb lending and investment after the economy grew at the fastest pace since 1994. Lenders must put aside 12% of deposits as reserves, starting Aug. 15, up from 11.5%, the People's Bank of China said... China is trying to stop the flood of cash from record trade surpluses from fueling inflation, asset bubbles and overcapacity in manufacturing."

July 31 - Bloomberg (Wendy Leung): "Hong Kong's retail sales climbed a more-than-expected 14.3% in June from a year earlier as stock-market gains, rising wages and a low jobless rate encouraged spending."

India Watch:

July 31 - Bloomberg (Cherian Thomas): "India's central bank unexpectedly ordered lenders to set aside larger reserves for the third time this year to remove excess money that may stoke inflation."

Asia Boom Watch:

August 1 - UPI: "South Korea...reported a trade surplus of nearly $1.5 billion for July, its 52nd consecutive month of such positive performance. The commerce and industry ministry reported that July exports rose 20% to $30.9 billion from the same month of last year, driven largely by sales of automobiles and cell phones."

July 31 - Bloomberg (Seyoon Kim): "South Korea's service companies expanded at the fastest pace in almost five years in June, the latest indication that economic growth may accelerate."

Unbalanced Global Economy Watch:

August 2 - Bloomberg (Peter Woodifield): "U.K. farm land prices are rising at the fastest rate for 30 years, as bankers and traders flush with bonuses from a record year in the financial markets are joining mainly Irish foreign investors to buy farms and country estates. Prices rose 10% in the second quarter and 27% in the year to June 30, the most since 1977, London-based realtor Knight Frank said..."

July 31 - Bloomberg (Robin Wigglesworth): "Norway's domestic credit growth slowed to 14.7% in June as 11 interest rate increases in two years and the prospect of more to come began to take their toll on consumers' debt appetite. Credit growth for households, companies and municipalities eased from 14.8% in May..."

August 2 - Bloomberg (Maria Levitov): "Russia's former acting Prime Minister Yegor Gaidar said inflation will probably surpass the government's target and reach 8.6% this year. 'When your economy depends on oil and gas prices and these prices are abnormally high, monetary risks emerge,' Gaidar, director of The Institute for the Economy in Transition, said... The government aims to slow inflation to 8% this year from last year's rate of 9%."

August 1 - Bloomberg (Mark Bentley): "Turkey's exports jumped 28% in July from a year earlier, the Turkish Exporters' Assembly said... Export growth accelerated from 17% in June."

July 31 - Bloomberg (Nasreen Seria and Mike Cohen): "South African credit growth unexpectedly accelerated to an annual 24.9% in June, adding pressure on the central bank to raise interest rates... The pace of growth in borrowing by households and companies accelerated from 24.8% in May..."

Latin American Boom Watch:

July 31 - Bloomberg (Patrick Harrington): "Bank of Mexico economist Manuel Ramos Francia said the recent acceleration of inflation in the country was caused by a food 'supply shock' and not a general increase in consumer prices."

August 1 - Bloomberg (Eliana Raszewski): "Argentina's tax revenue rose 37.7% in July from a year earlier as the economy heads into a fifth straight year of growth."

July 31 - Bloomberg (Helen Murphy): "Colombia's imports rose 24.8% in May from a year earlier, helped by a surge in purchases of automobiles and car parts."

Central Banker Watch:

August 3 - Bloomberg (Helene Fouquet): "European Central Bank President Jean-Claude Trichet, likening inflation to a drug, said the bank may raise interest rates next month to keep prices stable. 'Strong inflation is a bit of a drug,' Trichet told Europe 1 radio in an interview... 'It gives you immediate satisfaction and then you pay a high price for it.'"

Mortgage Finance Bubble Watch:

August 3 - Bloomberg (Chen Shiyin and Pimm Fox): "The U.S. subprime-market rout that wiped out $2.1 trillion from global share values last week has 'got a long way to go,' said Jim Rogers... 'This was one of the biggest bubbles we've ever had in credit,' Rogers, chairman of New York-based Beeland Interests Inc., said in an interview from Hong Kong."

August 3 - Bloomberg (Kathleen M. Howley and Jody Shenn): "U.S. mortgage lenders such as Wells Fargo & Co. and Wachovia Corp. are raising rates and imposing stricter standards on some of their most creditworthy borrowers as slumping demand in the mortgage bond market chokes off funding. ...Wells Fargo, the second-biggest U.S. home lender, curbed its funding of Alt-A loans, made to borrowers with near-prime credit ratings or prime borrowers who don't document income. ...Wachovia, the fourth-largest U.S. bank, also stopped making Alt-A loans through brokers and smaller lenders and curtailed some adjustable rate mortgages, spokeswoman Christy Phillips-Brown said. 'The credit crunch is here,' said Keith Shaughnessy, president of Foundation Mortgage Corp."

August 2 - Bloomberg (Jody Shenn and Bradley Keoun): "IndyMac Bancorp Inc. is joining rival lenders in making 'very major changes' to loan standards and raising interest rates because of a slump in mortgage securities, an e-mail to the company's employees said. The market for mortgage bonds has become 'very panicked and illiquid,' Chief Executive Officer Michael Perry wrote... National City Corp. yesterday told companies from which it buys loans that it won't accept second mortgages and some low-documentation loans... Wachovia Corp. today decided to stop making Alt A mortgages through brokers in one of its mortgage units. 'Unlike past private secondary mortgage market disruptions, which have lasted a few weeks or so, our industry and IndyMac have to be prudent and assume that this present disruption, which appears broader and more serious, might take longer to correct itself,' Perry wrote. The additional credit tightening by IndyMac, the ninth largest U.S. mortgage lender, and competitors on loans considered less risky than so-called subprime, comes at a time when it's 'difficult' to trade even AAA-rated mortgage bonds that aren't guaranteed by government-chartered Fannie Mae and Freddie Mac, or federal agency Ginnie Mae, Perry wrote."

August 2 - Bloomberg (Bradley Keoun): "American Home Mortgage Investment Corp. plans to halt operations, becoming the second-biggest residential lender to fail this year as bad loans spread to people with good credit records. The last day for most employees will be tomorrow, Chief Executive Officer Michael Strauss told the staff... Investment bankers cut off credit earlier this week, leaving the... company unable to fund at least $750 million of mortgages promised to thousands of now-stranded borrowers. 'Conditions in both the secondary mortgage market as well as the national real estate market have deteriorated to the point that our business is no longer viable,' Strauss wrote today."

Foreclosure Watch:

July 30 - Bloomberg (Kathleen M. Howley): "U.S. foreclosures rose 58% in the first half of 2007 from a year earlier, led by California and Florida, as more homeowners fell behind on their monthly mortgage payments, RealtyTrac Inc. said. Lenders sent notices of default, scheduled auctions or repossessions to 573,397 properties in the January to June period... California foreclosures surged 170% to 104,572, the highest in the nation, and Florida gained 77% to 64,250."

Real Estate Bubbles Watch:

August 2 - The Wall Street Journal (Ryan Chittum and Kemba J. Dunham): "The fuel behind the skyrocketing commercial real-estate prices of the past three years -- cheap debt and easy lending terms -- is running low. As a result, high-risk buyers might be left behind and the pace of real-estate companies going private might slow. Low-cost loans with lenient terms have propelled the commercial-real-estate market to what many feared was an unsustainable level. The boom was propped up by the commercial-mortgage-backed securities markets, which allowed banks to issue mortgages, pool them and sell them as bonds. With less risk on their books, banks were able to lend with cheaper rates and looser terms, making it easier for private-equity firms to buy huge portfolios and real-estate investment trusts. The buying frenzy culminated in Blackstone Group's landmark, $23 billion acquisition of Equity Office Properties Trust in February. Many of those EOP properties were quickly flipped at even higher prices. In the past few weeks, though, nervous buyers of these commercial securities have pulled out of the market altogether or demanded sharply higher yields, fearing that many transactions were too risky. That has forced lenders to raise interest rates, increasing the cost of buying real estate."

August 2 - Bloomberg (Dan Levy): "The Italian palazzo-style home in San Francisco's Pacific Heights neighborhood has a living-room view of the Golden Gate Bridge and Alcatraz Island, and billionaires Gordon Getty and Larry Ellison for neighbors. What the house doesn't offer is a security system, a renovated kitchen, or updated fixtures in the 7 1/2 bathrooms. Both the heating and plumbing systems are original to the 1927 structure. That isn't stopping the seller from listing the seven-bedroom house for $55 million -- more than double the highest price ever paid for a San Francisco residence. 'You don't have the fancy granite, marble and luxury finishes you'd expect in a $55 million house,' said broker Joseph Moore of Alain Pinel Realtors. 'It's a fixer.'"

Energy Boom and Crude Liquidity Watch:

August 2 - Bloomberg (Matthew Brown): "High inflation in the Persian Gulf will slow real gross domestic product growth, Gulf News reported, citing a report from the National Bank of Dubai. Rising costs are hampering economic diversification away from oil in the region as they deter foreign investors, Gulf News said..."

July 31 - Bloomberg (Matthew Brown): "Qatar's annual inflation slowed to 12.8% in the second quarter from 14.8% in the first as increases in the cost of housing eased."

Speculator Watch:

July 31 - Bloomberg (Jenny Strasburg and Katherine Burton): "Sowood Capital Management LP lost 50% in July, or about $1.5 billion, the biggest hedge-fund manager to collapse after declines in the corporate bond and loan markets. Sowood sold most of its assets to Citadel Investment Group LLC and will unwind its two funds, Jeff Larson, founder...told investors... Sowood sought a buyer when it couldn't meet lenders' demands for more collateral... 'The transaction enabled us to avoid anticipated forced sales at extreme prices,' Larson, a former Harvard University endowment manager, said in the letter. 'The weakness in corporate credit, particularly focused on loans and loan credit-default swaps, accelerated sharply during the week of July 23.' The firm's credit holdings plummeted in value as investors shunned riskier debt such as subprime mortgages and bonds used to fund leveraged buyouts... Sowood's Alpha Fund Ltd. lost 57% in the month and Alpha Fund LP dropped 53%. The funds plunged 56% and 51% for the year... 'It's mind-boggling,' said Bradley Alford, a former investment manager at the Duke University endowment who runs Atlanta-based money-management firm Alpha Capital Management LLC. 'This last week, the velocity of losses has picked up dramatically. The models work when they look at history, but not when history is all new.'"

July 31 - Financial Times: "Forget vulture funds that feed on the carcasses of dying companies or investment vehicles by snapping up chunks of distressed debt. Citadel is proving to be more of a whale - simply swallowing them whole. Last year, the $14bn hedge fund teamed up with JPMorgan Chase to ingest Amaranth's positions at bargain rates when the $9bn hedge fund made disastrous bets on natural gas. Its latest move is to buy Sowood's credit portfolio, after the once-$3bn hedge fund saw its value halve as a result of bad bets... Unlike some funds that manage many billions of dollars with small staffs, Citadel employs more than 1,000 people."

July 31 - Bloomberg (Neil Unmack and Jacqueline Simmons): "Oddo & Cie, a French stockbroker and money manager, plans to close three funds totaling 1 billion euros ($1.37 billion), citing the 'unprecedented' crisis in the U.S. asset-backed securities market. Oddo said it will wind down the funds within the 'shortest possible time frame' after struggling to value holdings of collateralized debt obligations... 'Like many actors, we have tried to revitalize the performance of our funds by investing in CDOs,' Arnaud Ploix, a spokesman for...Oddo, said... 'Like others, we noticed recent problems with short-term liquidity and were caught out by the subprime dilemma.'"

July 31 - Bloomberg (Aaron Pan): "London raised average daily currency trading in April to more than double the level of New York, extending its lead as the world's largest center for foreign exchange... Trading rose to an average $1.34 trillion a day in London, a 27% gain from October, while in New York it grew 16% to $618 billion..."

Credit Market Dislocation:

July 31, 2007: "C-BASS LLC, an affiliate of MGIC Investment Corporation and Radian Group Inc. today issued the following statement in response to the announcements made last night by MGIC and Radian regarding the liquidity challenges faced by C-BASS. While nothing fundamentally has changed at C-BASS, like many other firms in the industry, the current severe state of disruption in the credit markets has caused C-BASS to be subject to an unprecedented amount of margin calls from our lenders. The frequency and magnitude of these calls have adversely affected our liquidity. To address this, C-BASS is in advanced discussions with a number of investors to provide increased liquidity and is exploring all options to mitigate the liquidity risk in this difficult market."

August 1 - Financial Times (Tim Bartz, Elisabeth Atzler, Joanna Chung, Paul J Davies and Stacy-Marie Ishmael): "The German government has pulled together a rescue operation - drawing in all three pillars of the country's banking system - to shore up Europe's first major casualty of the subprime crisis. The rescue of IKB, a specialist lender based in Dusseldorf, began on Sunday when Peer Steinbrück, the German finance minister, called leading banking executives to discuss a bailout. According to people who took part in the conference call, Jochen Sanio, head of Germany's financial regulator, is said to have warned of the worst banking crisis since 1931."

August 2 - Financial Times (Gillian Tett): "Bitter disputes are developing behind the scenes in the hedge fund industry about the way funds are valuing some assets for their end-of-month performance reports. In particular, the recent violent swings in the credit markets are making it unusually hard for some funds to agree the value of these assets with their administrators... That may mean investors will be forced to wait longer than usual for performance reports about the net asset value (NAV) of hedge funds' portfolios in July. It may even form fertile ground for future lawsuits, since sharp differences in the perceived value of hedge fund portfolios could influence investor confidence. 'There is a lot of wrangling going on behind the scenes, because it's getting hard to agree [about] how to value a lot of stuff,' says one US banking official. 'The bid-offer spreads can be incredibly wide - and that can really affect the NAV...' The data on funds' NAV for the end of July is currently awaited with particular eagerness by many credit funds, since some are believed to have suffered painful losses as a result of the recent market turmoil - not only in the subprime sector but corporate credit markets in general. Indeed, many bankers assume there will be further hedge fund implosions during coming weeks, adding to the list of those already forced to close their doors, or to take extreme measures such as banning investor redemptions."

August 2 - Financial Times (Paul J Davies, Gillian Tett, Joanna Chung and Stacy-Marie Ishmael): "When an ordinary sounding Australian mutual fund run by Macquarie Bank's asset management division warned investors they could lose up to 25% of their money this week it was shocking for two reasons. First, it was a retail fund, so the investors were everyday people. Second, their money had not been anywhere near US subprime mortgages... The fund was actually invested in senior secured corporate loans, which are mainly the leveraged debt used in private equity-backed buy-outs - and these assets were fundamentally sound and performing well, the fund insisted. What caused the embarrassing loss was 'supply-demand imbalances' in the market - which in plain English means many need to sell but few want to buy. The saga illustrates an ominous point, namely that as market turmoil rises, financial problems are no longer simply confined to a risky corner of the US mortgage market. This stems from another key theme now haunting the markets: namely that liquidity is evaporating from numerous corners of the financial world, as both investors in hedge funds and the banks that lend to them try to cut and run from recent losses... 'In many ways, this episode is similar to the LTCM crisis in 1998, as margin calls on leveraged investors are forcing them to sell illiquid assets into unreceptive markets at ever-lower prices,' says Larry Cantor of Barclays Capital."

August 3 - The Wall Street Journal (Victoria Howley, Kate Haywood, and Marietta Cauchi): "The big chill gripping global credit markets has caused 46 leveraged financing deals around the world to be pulled since June 22, representing more than $60 billion in funding that companies had planned for mergers and acquisitions. The number of deals pulled last year: zero. The credit squeeze has slowed to a trickle the flood of debt financing that has driven the buyout boom for the past couple of years. None of the 46 pulled financings have led to the cancellation of takeovers. But with banks saddled with billions of dollars of debt they can't sell to investors, it could make it harder for other deals to get initial financing from banks. Already, some companies that had put themselves on the auction block are shelving sale plans."

August 3 - Financial Times (Peter Thal Larsen): "Leading bankers on Thursday moved to calm the global markets even as they admitted that the shockwaves from of the US subprime collapse could put private equity deals on hold for the next few months. Shares in European and US banks have slumped in the past week as investors have fretted about their exposure to subprime-related losses as well as leveraged loans stuck on their balance sheets. Analysts estimate large banks have underwritten loans worth $300bn to finance deals not yet been completed."

August 3 - Financial Times (Kate Burgess): "Axa Investment Managers, the Paris-based asset manager, has taken a highly unusual step to shore uptwo of its funds hit by the turmoil in the subprime market in order to protect its brand. The group said it would invest its own money in both funds to ensure their liquidity while allowing all investors to sell their holdings if they wish. The objective of the two funds, both named US Libor Plus, was to pay a return of 50 bps above the one month US Libor. However, the assets of both funds have fallen by about 21% since the beginning of July. About 41% of both funds, which between them have about $712m under management, were invested in subprime mortgages... Some in the industry said the names of the funds 'were unfortunate', since they might have been construed as lower-risk money market funds..."

August 3 - Dow Jones (Danielle Reed ): "As fallout from subprime mortgage troubles continues, commercial mortgage bond investors are watching risk premiums widen like it's 1998. Though commercial mortgage bonds - especially the AAA classes - were long seen as safer and more stable assets than subprime mortgage bonds, now even prices for AAA commercial mortgage bonds are falling. The market has seen selling of AAA commercial mortgage bonds in recent sessions, amid talk that hedge funds and other investors who bought the bonds with borrowed money may have been forced to make those sales."

August 3 - Bloomberg (Darrell Hassler): "Sales of bonds backed by low-rated commercial loans have stalled as investors demand higher interest rates amid an onslaught of debt to finance leveraged buyouts, according to RBS Greenwich Capital. There hasn't been a sale in the U.S. since July 25 of collateralized debt obligations with a rating below AAA that are backed by mortgages for hotels, apartment buildings or offices, RBS analyst Lisa Pendergast wrote in a report yesterday."

August 3 - CNBC (Diana Olick's blog): "They're pulling themselves out of the market to regroup," is what one of my mortgage broker buddies told me on the phone this morning when I asked how in the heck Wells Fargo could raise rates on a 30-year jumbo fixed rate mortgage from 6 7/8% to 8% overnight. A jumbo is anything over $417,000, and given today's home prices, that's going to hit an awful lot of borrowers."

August 3 - Bloomberg (Jody Shenn): "The perceived risk of AAA rated subprime-mortgage securities surged after Wells Fargo & Co., Wachovia Corp. and other lenders tightened standards on less risky homeowner debt, benchmark credit-derivatives prices show. An index of credit-default swaps linked to 20 bonds rated AAA and created in the second half of 2006 fell 2.4% to a new mid-price low of 87.5... The ABX-HE-AAA 07-1 index has dropped by more than 11% since June, suggesting a similar fall in the value of the bonds. An index tracking BBB- rated securities also fell to a new low."

I'm never comfortable with the idea of "yelling 'fire' in a crowded theater." But Jim Cramer already did as much late this afternoon on CNBC. His "we're in Armageddon" tirade (available at CNBC.com) was made moments after Bear Stearns' CFO Samuel Molinaro offered a disconcerting assessment of market conditions during the company's hastily called conference call: "I've been out here for 22 years, and this is as bad as I've seen it in the fixed-income markets." A highly-aroused Mr. Cramer, volunteering to speak on behalf of Wall Street, called for the Fed to aggressively cut rates and "open the discount window."

The Credit system has Dislocated, liquidity has evaporated, and our academically-inclined new Fed chairman is in store for a historically challenging real world first test. Wall Street has been conditioned over the years to expect "bailouts." Only months on the job, Alan Greenspan stepped up and assured the markets that the Fed was ready to add liquidity after the '87 stock market crash. The Greenspan Fed acted aggressively during the LTCM crisis and, later, Dr. ("Helicopter") Bernanke played an instrumental role in the Fed talking the risk markets higher in late 2002. To be sure, Fed "reliquefications" played a conspicuous role in fostering ever greater and more unwieldy Bubbles, and this will remain in the back of FOMC members' minds. The Bernanke Fed today would likely prefer to maintain a "hands off" approach for as long as possible - which has already been too long for an acutely fragile "Wall Street."

And let's not forget the GSE "backstop bid." The GSE's ballooned their balance sheets $150bn to absorb speculative de-leveraging during the 1994 bond market rout - about double 1993's at the time record asset expansion. GSE balance sheets (largely holdings of mortgages and MBS) ballooned $305bn during tumultuous 1998, $317bn during 1999, $238bn in 2000, and $344bn during liquidity challenged 2002. Agency balance sheets grew $37bn last year. The GSE's are definitely in no position these days to aggressively create marketplace liquidity through the expansion of their balance sheets (issue debt to expand holdings of MBS). Wall Street must all of the sudden feel short of friends.

Appearing this evening with Larry Kudlow, Larry Lindsey called upon Fannie and Freddie to loosen lending standards to help ameliorate the rapidly accelerating Mortgage Credit Crunch. I was immediately reminded of how Washington nurtured the $200bn (or so) S&L bailout from what should have been resolved years earlier at a fraction of the cost to taxpayers. The GSE tab is today running out of control. Keep in mind that Fannie and Freddie already have combined "Books of Business" (MBS holdings and guarantees) of almost $4.0 TN supported (in the best case) by stockholders' equity in the neighborhood of $60bn (current financial statements not available!). The thinly-capitalized Federal Home Loan Bank System has another $1.0 TN of assets. Before all is said and done, taxpayer GSE exposure will likely reach the trillions - to add to other untenable ballooning federal contingent liabilities.

This week, the unfolding financial crisis reached a problematic stage on several fronts. For one, illiquidity hit the gigantic "AAA" market for "private-label mortgage-backed securities." The booming market for non-agency MBS has played an instrumental role in ensuring abundant cheap mortgage Credit - on the one hand filling the liquidity void created by the constrained GSEs (balance sheets) and, on the other, providing virtually unlimited inexpensive "jumbo" mortgage finance to inflate upper-end housing Bubbles in California and the most desirable locations and neighborhoods across the country.

While the subprime implosion was a major marketplace development, in reality only a small segment of the mortgage marketplace was actually impacted by significantly tighter Credit conditions. Today, we are in the throes of a dramatic, broad-based and momentous tightening of mortgage Credit. Importantly, key players and sectors throughout the mortgage risk intermediation process are increasingly impaired and now in full retreat. This includes entities such the mortgage insurers, MGIC's and Radian's faltering C-BASS securitization unit, REITs such as failed American Home Mortgage and others, hedge funds such those that failed at Bears Stearns and many more, the broker/dealer community and the mortgage derivatives market generally. There is also the issue of exposed mutual funds, money market funds, pension funds and the banking system in general. Just like NASDAQ went to unimaginable extremes than then doubled during the final "blow-off" - total mortgage Credit doubled subsequent to the Greenspan Fed's reckless post-tech Bubble "reflation." Mortgage exposure now permeates the (global) system and is highly susceptible to "Ponzi Finance" dynamics.

The process of transforming risky mortgage loans into coveted perceived safe and liquid ("money"-like) Credit instruments has broken down on several fronts. Not only is the intermediation community impaired, marketplace confidence and trust in the quality, safety, and liquidity of mortgage (and mortgage-related) securities is being shattered. There are apparently serious problems developing throughout the massive marketplace for ("repo") financing MBS. And it is precisely the market for financing the top-rated mortgage securitizations - where the perceived risk was minimal - where I suspect the greatest abuses of leverage occurred. The marketplace is now experiencing forced de-leveraging and a liquidity Dislocation - with major systemic ramifications.

I mostly downplayed the marketplace liquidity and economic impact of the housing downturn last fall and the subprime implosion this past February. My view of current developments is markedly different. I cannot this evening overstate the dire ramifications for the unfolding Credit System Dislocation. There is today serious risk of U.S. financial markets "seizing up." A system so highly leveraged is acutely vulnerable to speculative de-leveraging and a catastrophic "run" from risk markets. At the same time, the Bubble Economy and inflated asset markets - by their nature - require uninterrupted abundant liquidity. The backdrop could not be more conducive to a historic crisis, yet most maintain unwavering confidence that underlying fundamentals are sound.

I am this evening unclear how the enormous ongoing new demand for California mortgage Credit will be financed going forward. With the market having lost all appetite for "jumbo" MBS, mortgages must now be priced generally in accordance with the standards of increasingly cautious loan officers willing to live with these loans on their banks' balance sheets (a radical departure from pricing set by originators selling loans immediately in an overheated MBS market). And, let there be no doubt, the prospective Credit tightening will hit grossly inflated and highly susceptible "Golden State" housing prices hard - a scenario that will force lenders to incorporate significantly higher Credit losses into their loan pricing terms (perhaps Cramer was speaking to CA homeowners when he jingled house keys in front of the camera during Wednesday's show and suggested it was perfectly rational to mail your keys to the bank). Furthermore, I expect the pricing and availability of Credit to refinance millions of rate-reset mortgages in California and elsewhere to turn prohibitive. And the home equity well is about to run dry - from a combination of sharply tightened Credit conditions and accelerating home price declines.

A severe tightening in mortgage Credit is in itself sufficient to pierce a vulnerable U.S. Bubble Economy. But there is as well an abruptly brutal tightening in corporate Credit. The junk bond market has basically closed for business. The leveraged loan marketplace is in turmoil and scores (46 - see WSJ above) of debt deals have pulled. And, more ominously, the previously booming ABS and CDO markets have slowed to a crawl. Perhaps not immediately, but it will not be long before the economy succumbs to recession.

Credit System Dislocation now dictates the assumption that Federal Reserve rates cuts are on the near horizon. And while they will likely incite the expected knee jerk response in the equities market, I don't expect they will have much lasting effect on our impaired Credit system. Current issues are much more complex and serious than '87, '98, 2000, or 2002. The dilemma today is that confidence in "Wall Street finance" has been shattered. The manic Bubble in Credit insurance, derivatives, and guarantees is bursting. The manic Bubble in leveraged speculation is in serious risk of bursting. The currency markets are a derivative accident in waiting. Fed rates cuts risk a dollar accident and/or a further destabilizing (for spreads) Treasury melt-up.

A focal point of my Macro Credit Analysis has for some time been the grave risks posed to markets and economies by the seductive elixir of speculative liquidity. I have compared the current backdrop to that of 1929. For too long our Bubble Economy and Bubble Asset Markets have luxuriated in liquidity created in the process of leveraging speculative securities positions (especially in the Credit market). We are now witnessing how abruptly euphoric boom-time liquidity abundance can transform to a liquidity crisis.

I apologize for appearing overly dramatic. But this evening I have feelings that for me recall the disturbing emotions following the terrible 9/11 tragedy. I know the world has changed and changed for the worse - yet I recognize that I don't know how and to what extent. I fear for our markets, our economy, our currency and our system. I received an email this week on my Bloomberg that said something to the effect, "You all must be happy in Dallas." I can tell you we're instead sickened by what has transpired during the late- stages of this senseless Credit and specualtive orgy. The Great Credit Bubble has been pierced, and there will now be a very, very heavy price to pay. And, as always, I hope I am proved absolutely wrong.

My apologies, but this Bulletin had to be thrown together quickly this evening. I may update it somewhat over the weekend.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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