Structured Finance Under Duress

By: Doug Noland | Fri, Oct 26, 2007
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For the week, the Dow gained 2.1% (up 10.8% y-t-d), and the S&P500 rose 2.3% (up 8.2%). The Utilities surged 4.8% (up 12.5%), and the Morgan Stanley Consumer index gained 2.0% (up 6.8%). The Morgan Stanley Cyclical index advanced 1.5% (up 18%) and the Transports 1.4% (up 6.7%). The broader market rallied sharply. The small cap Russell 2000 jumped 2.8% (up 4.3%), and the S&P400 Mid-Cap index gained 1.8% (up 11.3%). On the back of Microsoft's strong earnings, the NASDAQ100 rose 3.0%, increasing y-t-d gains to 24.9%. The Morgan Stanley High Tech index added 0.6% (up 17.8%). The Street.com Internet Index gained 2.7% (up 22.4%), and the NASDAQ Telecommunications index increased 1.3% (up 22.9%). The lagging Semiconductors dropped 4.9% (down 3.4%). Not lagging this week, the Broker/Dealers rallied 4.2% (down 3.5%), and the Banks recovered 3.1% (down 11.9%). With bullion surging $20 to $785.36, the HUI Gold index jumped 3.9% (up 24.3%).

Three-month Treasury bill rates increased 3 bps this week to 3.95%. Two-year government yields slipped 2 bps to 3.76%. Five-year yields added one basis point to 4.04%. Ten-year Treasury yields were unchanged at 4.39%, and long-bond yields were little changed at 4.69%. The 2yr/10yr spread ended the week at 63. The implied yield on 3-month December '08 Eurodollars dropped 5.5 bps to 4.115%. Benchmark Fannie Mae MBS yields declined 2 bps to 5.77%, this week somewhat outperforming Treasuries. The spread on Fannie's 5% 2017 note widened one to 47, and the spread on Freddie's 5% 2017 note widened 1 to 48. The 10-year dollar swap spread declined 0.4 to 64.1. Corporate bond spreads generally widened, as the spread on an index of junk bonds ended the week 23 bps wider.

Investment grade debt issuers included Agilent Tech $600 million, Washington Mutual $500 million, Union Pacific $500 million, and Panhandle Eastern $300 million.

Junk issuers included TXU $3.0bn, Energy Future Holdings $4.5bn, and Alliant Holdings $265 million.

Convert issuers included Lincare Holdings $500 million.

Foreign dollar bond issuance included VTB Capital $2.0bn, EDP Finance $2.0bn, Diageo Cap $1.5bn, American Movil $1.0bn, and EEB International $610 million.

German 10-year bund yields declined 3bps to 4.19%, as the DAX equities index added 0.7% for the week (up 20.4% y-t-d). Japanese 10-year "JGB" yields increased 1.5bps to 1.615%. The Nikkei 225 dropped 1.8% (down 4.2% y-t-d). Emerging equities were mostly higher, while their debt markets posted another solid performance. Brazil's benchmark dollar bond yields dipped one basis point to 5.71%. Brazil's Bovespa equities index surged 5.6% (up 44.5% y-t-d). The Mexican Bolsa added 1.0% (up 21.5% y-t-d). Mexico's 10-year $ yields fell 5 bps to 5.42%. Russia's RTS equities index gained 2.4% (up 14.2% y-t-d). India's Sensex equites index surged 9.5% (up 40% y-t-d). China's Shanghai Exchange fell 3.9%, reducing y-t-d gains to 109% and 52-week gains to 209%).

Freddie Mac posted 30-year fixed mortgage rates declined 7 bps this week to 6.33% (down 7bps y-o-y). Fifteen-year fixed rates fell 9 bps to 5.99% (down 11bps y-o-y). One-year adjustable rates dropped 10 bps to 5.66% (up 6bps y-o-y).

Bank Credit expanded $14.5bn during the week (10/17) to a record $9.026 TN. Bank Credit has now posted a 13-week gain of $382bn (17.7% annualized) and y-t-d rise of $729bn, a 10.9% pace. For the week, Securities Credit declined $18bn. Loans & Leases surged $32.5bn to a record $6.640 TN (13-wk gain of $316bn). C&I loans rose $2.0bn, increasing 2007's growth rate to 22%. Real Estate loans jumped $54.5bn, led by an unusual $52.3bn increase in "other" RE loans. Consumer loans declined $4.0bn. Securities loans fell $9.1bn, while Other loans dropped $11.0bn. On the liability side, (previous M3) Large Time Deposits surged $55.4bn (5-wk gain of $123bn).

M2 (narrow) "money" declined $12.5bn to $7.373 TN (week of 10/15). Narrow "money" has expanded $329bn y-t-d, or 5.8% annualized, and $436bn, or 6.3%, over the past year. For the week, Currency was unchanged, and Demand & Checkable Deposits were little changed. Savings Deposits declined $9.0bn, while Small Denominated Deposits added $1.0bn. Retail Money Fund assets fell $4.5bn.

Total Money Market Fund Assets (from Invest. Co Inst) surged another $50bn last week to a record $2.970 TN. Money Fund Assets have now posted a 13-week gain of $387bn (60% annualized) and a y-t-d increase of $588bn (30% annualized). Money fund asset have surged $716bn over 52 weeks, or 32%.

Total Commercial Paper increased $6.2bn to $1.872 TN. CP is down $351bn over the past 11 weeks. Asset-backed CP dipped $300 million (11-wk drop of $279bn) to $894bn. Year-to-date, total CP has dropped $102bn, with ABCP down $190bn. Over the past year, Total CP has declined $27bn, or 1.4%.

Asset-backed Securities (ABS) issuance increased to $9bn this week. Year-to-date total US ABS issuance of $496bn (tallied by JPMorgan) is running 32% behind comparable 2006. At $214bn, y-t-d Home Equity ABS sales are 54% off last year's pace. Year-to-date US CDO issuance of $272 billion is running 5% below 2006.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 10/23) jumped $12.4bn to $2.031 TN. "Custody holdings" were up $279bn y-t-d (19.2% annualized) and $345bn during the past year, or 20.5%. Federal Reserve Credit increased $0.8bn to $859bn. Fed Credit has increased $6.6bn y-t-d and $28.0bn over the past year (3.4%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.077 TN y-t-d (27% annualized) and $1.215 TN year-over-year (26%) to $5.888 TN.

Credit Market Dislocation Watch:

October 24 - Financial Times: "A few weeks ago, investors were in masochistic mode. A string of hefty writedowns from investment banks were greeted with rising share prices, on the assumption that the worst was now out in the open. Merrill Lynch appeared to take a 'kitchen sink' approach, with a massive $4.5bn writedown on collateralised debt obligations and subprime mortgages. Now it is clear that a large bathtub would have been more appropriate. Merrill on Wednesday increased the writedown to $7.9bn. That is shocking. How could Merrill have got the scale of its exposure to losses so wrong? Was it not conservative enough the first time round, factoring in instead some sort of price recovery in these illiquid instruments? Or was it simply unaware of the true depth of its problem?"

October 26 - Financial Times (Ben White and Michael Mackenzie): "Subprime mortgage anxiety continued to spread on Thursday as a leading derivatives index hit a new low and fears grew that Merrill Lynch and other banks could be forced into even bigger asset writedowns. Trading in the riskiest slice of the ABX index of bonds backed by home loans made in the second half of last year hit a new low of 18 cents. The risky slice of the index is down about 30% since the end of September when banks closed their books for the third quarter... The ABX decline has helped fuel speculation of further big asset writedowns by banks and insurance groups... William Tanona, Goldman Sachs analyst, said he expected [Merrill Lynch] to take an additional $4.5bn of writedowns in the fourth quarter on its remaining $20.9bn portfolio of CDOs and subprime mortgages. His estimate was based on movements in indices tracking the value of subprime mortgages and securities made up of those mortgages. 'While only a proxy, we believe this price action does not bode well for the firm's existing $5.7bn exposure in subprime mortgages,' Mr Tanona said. 'Second, the TABX index, which we have been using as a proxy for CDO assets, has also deteriorated 18-35% across all of the tranches with the most significant deterioration coming at the most senior levels.'"

October 25 - Dow Jones (Anusha Shrivastava): "Fresh evidence that the subprime mortgage problems are growing worse pummeled a leading derivative index Thursday, and caused investors to grow much more cautious about the prospects of bond insurers and financial institution American International Group Inc. Troubling data on subprime mortgage delinquencies and defaults released Thursday pushed the riskiest, BBB- portion of the closely watched ABX index based on mortgages made in the second half of 2006 to record lows...Even the less risky tranches of the index are much weaker, with the A and AA tranches hit the most. The single A slice of the index based on loans from the second half of 2006 is quoted at 28.5 cents, down from a close of 32.42 cents... 'After seeing the remit reports, people are saying it's time to go back into bomb shelters because the war continues unabated,' said Dan Nigro, ABS portfolio manager at Dynamic Credit Partners..."

October 26 - Associated Press: "Moody's...expects to complete a report by the middle of next week assessing how much damage decaying mortgage quality will wreak upon a type of investment known as a collateralized debt obligation, a person familiar with the review said... In the meantime, reports cutting credit ratings on CDOs will trickle out as they are completed, according to the person, who spoke on condition of anonymity... When Merrill Lynch wrote down the value of its portfolio by $7.9 billion this week, much of that was from investments in CDOs that lost value during the credit crisis this summer. At least 40 reports downgrading or considering downgrading billions of dollars in CDOs were issued Friday, though the agency declined to estimate the value of downgraded CDOs."

October 26 - Bloomberg (Jody Shenn and Shannon D. Harrington): "Moody's...cut the ratings of collateralized debt obligations tied to $33 billion of subprime mortgage securities that were downgraded this month, a decision that may force owners to mark down the value of their holdings. Securities with ratings as high as AAA from at least 45 CDOs were either cut or put on review for a downgrade..."

October 22 - Wall Street Journal Europe: "Vulture fund, bailout, stopgap, savior -- the super-SIV meant to reopen the short-term debt markets is being called a lot of things. What if the best way to describe it turns out to be 'failure'? That's not too far-fetched. Only Wachovia has publicly committed to back the fund since Citigroup, J.P. Morgan Chase and Bank of America unveiled it last Monday. It turns out that there is no easy way to drum up guarantees for a boatload of hard-to-price mortgage bonds and collateralized debt obligations, which are backed by pools of mortgage and other assets. Also, bankers are questioning the logic of the fund, which seems especially helpful to Citigroup, the sponsor of more than its share of SIVs, or structured investment vehicles."

October 24 - Dow Jones (Carrick Mollenkamp, Ian McDonald and Valerie bauerlein): "As three of the world's biggest banks try to finalize a rescue plan for some shaky investment funds, the funds themselves face mounting problems. The outlines of a new superfund - an effort led by Citigroup Inc., Bank of America Corp. and J.P. Morgan Chase & Co. that may include at least seven other banks - are still being hashed out, according to a person familiar with the situation. The three banks could present a formal structure to potential bank partners and funds as soon as next week. Meanwhile, the funds at the heart of the situation - known as structured investment vehicles, or SIVs - need to find investors for $100 billion in debt coming due in the next six to nine months, even as ratings firms continue to come out with reports that lower the ratings of securities in moves that could further depress the value of SIV holdings."

October 25 - Bloomberg (Shannon D. Harrington): "A U.S. Treasury-led effort to keep structured investment vehicles afloat 'has low odds of success' in part because investors are conflicted about whether to participate in the plan, according to Bear Stearns Cos. Investors are torn between whether to go along or hold out and 'ride along for free,' speculating it will improve the market enough that the SIVs can raise money through asset sales to repay debt holders, Bear Stearns strategist Steven Abrahams wrote..."

October 26 - Financial Times (Saskia Scholtes and Francesco Guerrera): "US companies are becoming increasingly risk-averse with their investments, holding on to record levels of cash as a buffer against turmoil in financial markets, according to a survey of chief financial officers and corporate treasurers. Corporate America's increased caution with its investments will make it more difficult for banks and hedge funds to restore normality to troubled markets such as the one for asset-backed commercial paper."

October 24 - Financial Times (Ben White): "Poor quarterly results from banks across the US over the past two weeks suggest credit problems once confined to high-risk mortgage borrowers are spreading across the consumer landscape, posing new risks to the economy and weighing heavily on the markets. US banks have raised reserves for loan losses by at least $6bn over the second quarter and by even larger amounts from last year, indicating financial executives believe consumers will be increasingly unable to make payments on a variety of loans. Banks are adding to reserves not just for defaults on mortgages, but also on home equity loans, car loans and credit cards. 'What started out merely as a subprime problem has expanded more broadly in the mortgage space and problems are getting worse at a faster pace than many had expected,' said Michael Mayo, Deutsche Bank analyst. 'On top of this, there is an uptick in auto loan problems, which may or may not be seasonal, and there is more body language from the banks that the state of the consumer was somewhat less strong [than thought].' Dick Bove, analyst at Punk Ziegel, said bank earnings indicated 'there are problems with consumer debt that extend beyond the well-known issues in the real estate markets. Auto loans are clearly a new area of concern'."

October 24 - Financial Times (Henny Sender and Saskia Scholtes): "Turmoil in the market for debt backed by commercial mortgages is hitting some private equity deals hard, raising financing costs and eroding the profitability of buy-outs that depend on cash flows from real estate. Carlyle Group's planned $6.3bn purchase of US nursing home operator Manor Care is among the deals to have been caught in a swift downdraft in the commercial mortgage-backed securities market... Carlyle...originally intended to raise $4.6bn by selling bonds backed by the value of Manor Care's real estate. As part of that deal, the private equity group also secured a promise from its bankers to cap interest costs, which meant its banks would be vulnerable to losses on the deal if rates rose for CMBSs. That possibility has grown in recent days as spreads on CMBSs have widened. Since the start of last week, the spreads...have gone up more than one full percentage point."

October 23 - Bloomberg (Neil Unmack): "The investment fund run by Washington state's King County, which includes the city of Seattle, may be downgraded by Standard & Poor's because it holds bonds sold by structured investment vehicles. The $4.08 billion King County Investment Pool has 3.8% of its assets in three 'distressed' SIVs including Cheyne Finance LLC, Rhinebridge LLC and Mainsail II LLC, S&P said... S&P may cut the fund's AAAf rating, the highest government investment pool grade."

Currency Watch:

October 24 - Financial Times (Peter Garnham): "The Hong Kong dollar yesterday hit the upper end of its trading band for the first time, prompting the Hong Kong Monetary Authority to refute speculation that it would abandon its peg against the US dollar. The territory's currency...rose to HK$7.7500 against the dollar for the first time since its trading band was set in May 2005. The Hong Kong dollar is pegged at HK$7.8 against the dollar, but since May 2005 has been allowed to trade between HK$7.75 and HK$7.85... Analysts said speculation had been increasing that the HKMA might ditch its peg against the dollar, or allow its currency to trade in a wider band, since a strengthening Chinese renminbi and a weakening US dollar were making the territory's imports more expensive."

October 22 - Bloomberg (Matthew Brown): "Iraq wants to diversify out of dollars to preserve the value of its foreign exchange reserves after the U.S. currency fell, the head of the central bank said. 'We would like to diversify, definitely,' Sinan al-Shabibi, governor of the Central Bank of Iraq, said in an interview in Washington today. 'This is a prudent policy.' Iraq joins Middle East oil producers, including the United Arab Emirates, Qatar, Kuwait and Syria in reducing dollar holdings or dropping their currency's peg to the dollar, in the past year. Iraq has about $21.5 billion in foreign reserves..."

October 24 - Bloomberg (Marcel van de Hoef and Danielle Rossingh): "Jim Rogers...said he is shifting all his assets out of the dollar and buying Chinese yuan because the Federal Reserve has eroded the value of the U.S. currency. 'I'm in the process of -- I hope in the next few months -- getting all of my assets out of U.S. dollars,' said Rogers, 65, who correctly predicted the commodities rally in 1999. 'I'm that pessimistic about what's happening in the U.S.'"

The dollar index declined 0.5% to 77.03. For the week on the upside, the South African rand increased 5.4%, the Australian dollar 3.6%, the Brazilian real 2.7%, the New Zealand dollar 2.6%, the Canadian dollar 1.7%, the Swedish krona 1.7%, the Norwegian krone 1.6%, and the Euro 1.5%. On the downside, the Thai baht declined 1.1%. This week the Canadian dollar traded to a new 33-yr high and the Australian dollar a 23-yr high.

Commodities Watch:

October 24 - Financial Times (Javier Blas): "The steel industry is braced for an increase of up to 50% in the contract price of iron ore next year as a result of strong demand from China and lagging supply, industry executives and analysts have warned... The iron ore spot market has already seen price increases of up to 145% over the past year."

October 22 - Bloomberg (Tan Hwee Ann): "Goldman Sachs JBWere Pty...raised its contract coking coal price forecasts 17%... The annual contract price of coking coal may rise to a record $140 a metric ton in the 12 months from April 1, from $98 this year..."

October 26 - Bloomberg (Halia Pavliva): "Platinum rose to a record and palladium climbed as the dollar fell to the lowest ever against the euro, bolstering the appeal of the precious metals as hedges against inflation."

October 22 - Wall Street Journal (Robert Guy Matthews): "The cost of shipping raw materials across the world's oceans has reached an all-time high, pushing up prices of grain, iron ore, coal and other commodities. The average price of renting a ship to carry raw materials from Brazil to China has nearly tripled to $180,000 a day from $65,000 a year ago. In some cases, ocean shipping can be more expensive than the cargo itself. Iron ore, for example, costs about $60 a ton, but ship owners typically are charging about $88 a ton to transport it from Brazil to Asia."

October 26 - Bloomberg (Tony C. Dreibus): "Corn climbed for a second day and soybeans rose to a three-year high as the weaker dollar encourages overseas buyers to purchase U.S. supplies. The U.S. currency fell to a record against the euro on speculation the Federal Reserve will cut borrowing costs again. The slumping dollar makes U.S. goods, including commodities, more attractive. 'The weak dollar is definitely a factor in the rally in the corn and beans,' said Jon Marcus, president of Lakefront Futures & Options LLC in Chicago."

October 26 - Financial Times (Javier Blas): "Fertiliser prices have surged this week to the highest level in at least a decade as farmers in Europe and North America prepare to plant more crops to cash in on high agricultural commodities prices. The prices of fertilisers have gone up by 50% in the past year and will add significantly to farmers' costs, helping to sustain record agricultural commodities prices, analysts said."

For the week, Gold jumped 2.6% to a 27-year high $785, and Silver surged 4.7% to $14.28. December Copper slipped 0.4%. November crude surged $4.91 to a record $91.86. November gasoline jumjped 4.9%, and November Natural Gas increased 2.5%. December Wheat dropped 6.5%. For the week, the CRB index rose 1.7% (up 12.6% y-t-d). The Goldman Sachs Commodities Index (GSCI) increased 2.0% (up 33.4% y-t-d).

Japan Watch:

October 24 - Financial Times (David Pilling and Jonathan Soble): "When official figures come out on Friday, they are likely to show that consumer prices in Japan have fallen for the eighth month in a row and fuel talk of the country's persistent deflation. But that is not how many hard-pressed Japanese consumers will see it. From their perspective life is getting more expensive, with the price of dozens of everyday items, including coffee, noodles, bread, set lunches, clothes, taxi fares and road tolls all rising. 'Prices are definitely going up, slowly but surely,' says Keiko Kikuya, a Tokyo resident... 'Things like meat and fish are inching up all the time. Clothes, too. And land prices in central Tokyo: there's a lot just opposite our house that's shot up in price." Price rises - a novel phenomenon in a Japan that has been stuck in deflation for 10 years - are stirring anger. In the northern city of Sendai, 1,000 protesters marched recently against a planned 5 per cent rise in the price of kerosene, which is used to heat homes. The disconnect between people's everyday experiences and those of statistically measured price movements poses a conundrum for the Bank of Japan, the central bank, as it has tried to track inflation. "

October 24 - Bloomberg (Lily Nonomiya): "Japan's exports grew at the slowest pace in two years in September as shipments to the U.S. fell, a signal that the nation's economic expansion may cool because of waning demand in its largest market. Exports rose 6.5% from a year earlier..."

China Watch:

October 26 - Financial Times (Richard McGregor): "China's economy is on target this year to achieve its fastest annual growth rate since 1993 after continued strong expansion in the third quarter in spite of a raft of government measures to control investment and credit growth. The economy grew at an annual rate of 11.5% in the third quarter on the back of robust investment and exports... Growth is now on track to surpass 11% this year, which would be the fastest annual increase in output since the 13.1% achieved in 1993. The figures suggest China's powerful growth remains unchecked, even after five interest rate rises this year, directives to state banks to cool lending, and repeated calls by the central government for tighter enforcement of environmental rules."

October 25 - Bloomberg (Nipa Piboontanasawat and Li Yanping): "China's economy, the biggest contributor to global growth, expanded 11.5% in the third quarter, adding pressure for faster currency appreciation and higher borrowing costs to curb inflation... A record trade surplus helped drive a 26.4% surge in factory and property spending in the first nine months, raising the risk of idle plants and bad loans as the global economy slows."

October 26 - Bloomberg (Wang Ying): "China, the world's second-biggest energy user, increased electricity consumption by 15% to 2.395 trillion kilowatt-hours, as the nation's economy expanded."

October 26 - Dow Jones: "Property prices in 70 of China's large and medium-sized cities rose 8.9% from a year earlier in September, the fastest pace of increase so far this year... The increase in prices accelerated from 8.2% in August..."

October 22 - Bloomberg (Li Yanping): "China's economy may expand 11.5% and the inflation rate will be 4.3% this year, said Wang Xiaoguang, an economist at the National Development and Reform Commission... Gross domestic product will likely be 11% in 2008 with inflation at 3.5 percent, Wang said. China may have a $257 billion trade surplus this year, as exports expand by 24%, outpacing import growth by 4 percentage points..."

October 22 - China Knowledge: "According to the latest statistics from the General Administration of Customs, China's imports of iron ore fines went up by 14.5% year-on-year to reach 250 million tons in the first eight months of this year. The import of 250 million tons iron ore fines worth US$19.61 billion, up 43.8% compared with the same period last year."

October 26 - Bloomberg (Kelvin Wong and Chia-Peck Wong): "Prices of luxury apartments in Hong Kong almost doubled in the past four years, according to an index compiled by real estate agency Midland Holdings Ltd... The average price of luxury apartments...has risen 90% to HK$9,800 ($1,264) a square foot..."

India Watch:

October 24 - Bloomberg (Robin Wigglesworth): "India's Finance Minister Palaniappan Chidambaram said planned curbs on offshore derivatives are aimed at improving disclosure in the stock market and not an outright ban on types of funds. 'All we are trying to do is ensure that there is greater transparency in the manner in which funds flow into India, and that investors are subject to some kind of due diligence,' Chidambaram told reporters... 'We are not imposing capital controls, we are not against any kinds of inflows, or discriminating between one flow or the other.'"

Unbalanced Global Economy Watch:

October 26 - Bloomberg (Simone Meier): "Money-supply growth in the euro region remained near a 28-year high in September, adding to signs inflation may accelerate. M3 money supply...rose 11.3% from a year earlier, after gaining 11.6% in August... The rate reached 11.7% in July, the highest since August 1979."

October 24 - Financial Times (Jenny Wiggins and Javier Blas): "When the United Nations held its annual World Food Day last week to publicise the plight of the 854 malnourished people around the world, its warning that there 'are still too many hungry people' was a little more anxious than usual. Finding food to feed the hungry is becoming an increasingly difficult task as growing demand for staples such as wheat, corn and rice brings higher prices. That is leading all nations - rich and poor - to compete for food supplies. Food security is not a new concern for countries that have battled political instability, droughts or wars. But for the first time since the early 1970s, when there were global food shortages, it is starting to concern more stable nations as well. 'The whole global picture is flagging up signals that we're moving out of a period of abundant food supply into a period in which food is going to be in much shorter supply,' says Henry Fell, chairman of Britain's Commercial Farmers Group. As agricultural commodities trade at record high levels, causing one food manufacturer after another to put up prices...countries are starting to question whether they can afford to keep feeding themselves. Wheat and milk prices have surged to all-time highs while those for corn and soya beans stand at well above their 1990s averages. Rice and coffee have jumped to 10-year records and meat prices have risen recently by up to 50% in some countries. 'The world is gradually losing the buffer that it used to have to protect against big swings [in the market],' says Abdolreza Abbassian, secretary of the grains trading group at the UN's Food and Agriculture Organisation. 'There is a sense of panic.'"

October 22 - Bloomberg (Maria Levitov): "The Russian economy expanded an annual 7.4% in the first nine months, Interfax reported, citing the Economy Ministry."

October 26 - Bloomberg (Maria Levitov): "Consumer prices in Russia have increased 1.5 percentage points more than last year as the government struggles to curb accelerating inflation. Prices rose 8.9% in the year... in comparison with 7.4% in the same period last year..."

October 24 - Financial Times (Neil Buckley and Javier Blas): "Russia is introducing Soviet-style price controls on some basic foods in an effort to prevent spiralling prices from denting the Putin administration's popularity ahead of parliamentary polls in December. The country's biggest food retailers and producers have reached an agreement, expected to be signed with the Russian government on Wednesday, to freeze prices at October 15 levels on selected types of bread, cheese, milk, eggs and vegetable oil until the end of the year. Russia's move is the latest sign of surging agricultural prices becoming an international political issue. Big retailers will limit their mark-up on those goods to 10%. China has also agreed to food price controls; Egypt, Jordan, Bangladesh and Morocco are increasing subsidies or cutting import tariffs to lower domestic prices. Rich countries are not immune: Italian consumer groups organised a pasta boycott last month in a protest over prices."

Latin America Watch:

October 26 - Bloomberg (Lester Pimentel): "The widespread suspicion that the government of President Nestor Kirchner has manipulated inflation data and the likelihood that his wife Cristina Fernandez de Kirchner will succeed him are transforming the Argentine bond market into a financial bloodbath. Argentina's benchmark inflation-linked bonds have tumbled 24% this year..."

Bubble Economy Watch:

October 22 - Bloomberg (Thomas R. Keene): "Corporate-tax receipts in the U.S. have slowed along with profit growth, and that means the federal budget deficit is likely to widen next year, according to FTN Financial economists. Job growth may suffer as well, they say. 'Just when it seemed the federal deficit was melting away to nothing, growth in federal receipts has collapsed,' writes Christopher Low... Lower corporate tax receipts imply less job creation, he says."

October 22 - Bloomberg (Poppy Trowbridge): "U.S. banks, burdened by loans they promised prior to the recent liquidity shortage, will curb their lending and may spark a broader credit crisis, the Wall Street journal reported. Banks now use tighter lending criteria as a result of losses suffered from defaults in subprime mortgages and the effect of lending commitments made before the crisis, which they still have to honor, the Journal said, citing Michael Bauer, an executive vice president at MainSource Financial Group Inc..."

October 24 - The Wall Street Journal (Ana Campoy): "Cold weather hasn't hit the Northeast yet, but record heating-oil prices mean high heating bills are on the way for many residents. About eight million U.S. households -- largely in New England and the Central Atlantic states -- rely on heating oil to run their furnaces each winter. Last week, heating-oil futures hit a record of $2.36 a gallon, up more than 40% since the start of the year."

Central Banker Watch:

October 25 - Bloomberg (Patrick Harrington): "Mexico's central bank unexpectedly raised its benchmark interest rate by a quarter percentage point after a report showed core inflation quickened more than expected. The five-member board lifted the benchmark rate to 7.50 percent..."

California Watch:

October 24 - California Association of Realtors (CAR): "Home sales decreased 38.9% in September in California compared with the same period a year ago, while the median price of an existing home fell 4.7%... this decline -- which was both the largest month-to-month percentage decline on record and the first year-to-year decline in more than 10 years -- was mainly the result of the credit or liquidity crunch..." said C.A.R. President Colleen Badagliacco. ]California's sales fell more steeply than those of the U.S. as a whole because of its heavy reliance on jumbo loans..." The median price of an existing, single-family detached home in California during September 2007 was $530,830, a 4.7% decrease over...September 2006... The September 2007 median price fell 9.9% compared with August's $588,970 median price. 'The impact of the credit crunch spread throughout all tiers of the market in September,' said C.A.R. Vice President and Chief Economist Leslie Appleton-Young. 'While the entry-level portion of the market has been adversely affected by the subprime situation and tighter underwriting standards for much of this year, the high end of the market also saw a decline in sales, as even well-qualified buyers were affected by the lack of funds available for jumbo loans.' ...C.A.R.'s Unsold Inventory Index for existing, single-family detached homes in September 2007 was 16.6 months, compared with 6.4 months (revised) for the same period a year ago."

October 24 - Bloomberg (Michael B. Marois): "Four years after Arnold Schwarzenegger was elected governor of California, vowing to 'tear up the state's credit card,' the actor and former body-builder is about to charge $7 billion to taxpayers' accounts. California is selling notes tomorrow due in eight months to help pay its bills until tax revenue comes in, the largest short-term loan since Schwarzenegger took office and almost five times more than last year. Debt is increasing after cash receipts fell $777 million below the state's projections during the first three months of the fiscal year that started July 1... The rise in IOUs is an early sign that finances are deteriorating after four years of revenue growth... 'A California budget crisis is beginning to recur, and the big increase in short-term seasonal borrowing is the classic leading indicator,' said Richard Larkin, a municipal bond analyst at J.B. Hanauer & Co....a...money manager that oversees $10 billion."

Structured Finance Earnings Watch:

October 25 - Bloomberg (Christine Richard): "MBIA Inc., the world's biggest bond insurer, plunged the most in 20 years after the company reported its first loss, ended a share buyback and failed to quell speculation it will write down more of its mortgage portfolio. The company today reported a $36.6 million loss after reducing the value of the securities it guarantees by $342 million... MBIA...and Ambac Financial Group Inc...both reported their first losses... The insurers write derivative contracts promising to pay holders in the event of a default. The value of the securities plummeted after subprime delinquencies soared. 'People began to question the viability of the business model and the tremendous credit exposure that MBIA has taken on to a wide range of structured credit risks,' said David Einhorn, president of Greenlight Capital..."

October 24 - Bloomberg (Christine Richard): "Ambac Financial Group Inc., the World's second-largest bond insurer, reported its first quarterly loss after reducing the value of subprime mortgage-linked securities by $743 million. The shares fell the most in 2 1/2 years after...it had a third-quarter net loss of $360.6 million... Ambac, MBIA Inc. and other bond insurers have guaranteed billions of dollars of AAA rated collateralized debt obligations that are backed by low investment-grade rated portions of mortgage-backed debt... 'They have to show that they can survive a rough patch,' said Scott MacDonald, head of research at Aladdin Capital Management... 'They have to demonstrate that their business model is sustainable.'"

October 25 - Bloomberg (Christine Richard): "Security Capital Assurance Ltd., the Hamilton, Bermuda-based financial insurer and reinsurer, reported a third-quarter loss because of a $131.7 million markdown on credit derivatives."

GSE Watch:

Fannie Mae and Freddie Mac's combined "Book of Business" (mortgages retained and MBS guaranteed) expanded a notable $67.1bn during September, a 17% annualized rate, to $4.784 TN. Through nine months, their "Books of Business" have expanded $430bn, or 13.2% annualized. By category, their combined Retained Portfolio has expanded $8.6bn to $1.437 TN, while their guaranteed MBS exposure has increased $421bn to $3.347 TN.

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

October 24 - Bloomberg (Jody Shenn): "European and Asian investors will avoid most U.S. mortgage-backed securities for years without guarantees from government-linked entities, creating 'an enormous drag on the U.S. housing market,' according to UBS AG. During the current 'shutdown' of the subprime and Alt-A mortgage-securities markets, it's been 'virtually impossible' to find buyers for anything but the safest classes of such bonds...UBS analysts led by Laurie Goodman wrote... Surging losses on the loans will worsen as the credit crunch makes it harder for borrowers with adjustable-rate mortgages to lower their payments by refinancing, they wrote. Foreclosures started on U.S. loans rose at the highest rate on record in the second quarter, the Mortgage Bankers Association says. 'The `virtuous' cycle of the past few years has evolved into a 'vicious' cycle,' the UBS analysts wrote."

October 22 - Bloomberg (Andrew Blackman): "Californian homes are overvalued by as much as 40% and stricter lending standards will probably contribute to 'material' price declines, according to analysts at Goldman Sachs. Prices in the state 'have proven surprisingly resilient, given the severe curtailment of credit availability and rising unemployment,' the analysts said... 'However, we believe that a downturn is imminent.' In August, the median price for houses in California was $589,000, though economic conditions only support prices of $350,000 to $380,000, the analysts said."

October 26 - DataQuick Information Systems: "Lenders started formal foreclosure proceedings on a record number of California homeowners last quarter, the result of declining home prices, sluggish sales and subprime mortgage distress, a real estate information service reported. A total of 72,571 Notices of Default (NoDs) were filed during the July-to-September period, up 34.5% from 53,943 during the previous quarter, and up 166.6% from...third-quarter 2006... Last quarter's default level passed the previous peak of 61,541 reached in first-quarter 1996... 'We know now, in emerging detail, that a lot of these loans shouldn't have been made. The issue is whether the real estate market and the economy will digest these over the next year or two, or if housing market distress will bring the economy to its knees."

Mortgage Finance Bust Watch:

October 24 - The Wall Street Journal (Ruth Simon and James R. Hagerty): "Subprime mortgages aren't the only challenge facing Countrywide Financial Corp., the nation's biggest home-mortgage lender. Some loans classified as prime when they were originated are now going bad at a rapid pace. These loans are known as option adjustable-rate mortgages, or option ARMs. They typically have low introductory rates and allow minimal payments in the early years of the mortgage. Multiple payment choices include a minimum payment that covers none of the principal and only part of the interest normally due. If borrowers choose that minimum payment, their loan balances grow - a phenomenon known as 'negative amortization...' Among option ARMs held in its own portfolio, 5.7% were at least 30 days past due as of June 30, the measure Countrywide uses. That's up from 1.6% a year earlier. Countrywide held $27.8 billion of option ARMs as of June 30, accounting for about 41% of the loans held as investments by its savings bank. An additional $122 billion have been packaged into securities sold to investors, according to UBS... It now appears that many borrowers who moved into option ARMs were attracted by the low payments and may have been staving off other financial problems. More than 80% of borrowers who are current on these loans make only the minimum payment, according to UBS... Of the option ARMs it issued last year, 91% were "low-doc" mortgages in which the borrower didn't fully document income or assets, according to UBS, compared with an industry average of 88% that year. In 2004, 78% of Countrywide's option ARMs carried less than full documentation. Countrywide also allowed borrowers to put down as little as 5% of a home's price and offered 'piggyback mortgages,' which allow borrowers to finance more than 80% of a home's value without paying for private mortgage insurance. By 2006, nearly 29% of the option ARMs originated by Countrywide and packaged into mortgage securities had a combined loan-to-value of 90% or more, up from just 15% in 2004, according to UBS."

October 24 - Bloomberg (Laura Cochrane): "Collateralized debt obligations with investments related to U.S. home loans taken out in 2006 and this year will probably have their ratings cut by credit assessors, according to Barclays Capital. Some securities with the highest investment-grade rating of AAA may be lowered by two levels because of the 'tsunami' of ratings cuts to U.S. residential mortgage-backed securities that underlie the debt, Barclays's analysts said..."

October 26 - Bloomberg (Jody Shenn): "Late payments and defaults among subprime mortgages packaged into bonds rose last month as higher loan rates and weaker home prices pushed homeowners to the brink, according to data for loans underlying ABX derivative indexes. After September mortgage payments, 21.3% of the loan balances from 20 deals created in the first half of 2006 were at least 60 days late, in foreclosure, subject to borrower bankruptcy or already turned into seized property, up from 19.7% a month earlier..."

October 24 - Financial Times: "California pension fund Calpers assumed the ground beneath its feet was a safe place to park some of its $250bn of assets. The fund has invested billions of dollars in land and residential housing projects over the past 15 years, often within its home state. Those projects earned Calpers some of its highest returns before the US housing market hit a wall. But the fund now has hundreds of millions of dollars tied up in US 'land banks' which are struggling to deal with undeveloped acreage home builders no longer want... Calpers reported $1.12bn of investments in ventures managed by leading land banks Hearthstone, IHP and MacFarlane, as of March 31."

October 24 - Bloomberg (Laura Cochrane): "Standard & Poor's may cut the credit ratings of 207 Australian and New Zealand residential mortgage-backed securities as turmoil in the U.S. subprime market spreads to home-loan insurers. It's the first time in five years S&P has put securities backed by Australian and New Zealand mortgages on negative 'creditwatch.'"

Foreclosure Watch:

October 25 - Bloomberg (Alison Vekshin): "About 2 million subprime borrowers will lose their homes to foreclosure through 2009, costing them $71 billion in housing wealth, a congressional report said. Subprime foreclosure rates will increase as housing prices stagnate or decline, and the effects of the subprime crisis may spill over to the broader economy, according to a report by the Joint Economic Committee..."

Real Estate Bubbles Watch:

October 25 - Bloomberg (Kathleen M. Howley): "A record 17.9 million U.S. homes stood empty in the third quarter as lenders took possession of a growing number of properties in foreclosure. The figure is a 7.8% gain from a year ago...the U.S. Census Bureau said... About 2.07 million empty homes were for sale, compared with 1.94 million a year earlier, the report said."

October 22 - PRNewswire: "Single-family home sales in September fell 18.7% in Massachusetts, the steepest monthly decline in a year. But the third quarter still experienced less dramatic decreases than the second quarter, according to a report released today by The Warren Group... Single-family home sales fell from 4,593 in September 2006 to 3,735 in September 2007, a decrease of 18.7%."

Fiscal Watch:

October 24 - Bloomberg (Brian Faler): "The wars in Iraq and Afghanistan would cost almost $2.4 trillion if the U.S. keeps even a reduced number of troops in the two countries for the next decade, according to the Congressional Budget Office. Peter Orszag, head of the nonpartisan agency, told the House Budget Committee that it would cost $1.055 trillion to keep a reduced number of troops in the two theaters -- 75,000, down from the current 200,000 -- through 2017. If the conflicts continue to be funded with borrowed money, interest payments would total $705 billion. Those bills, when combined with the $604 billion Congress has already appropriated for the conflicts, would bring total costs to $2.364 trillion, according to CBO estimates. By comparison, President George W. Bush proposed a federal budget this fiscal year of $2.9 trillion."

Speculator Watch:

October 23 - Bloomberg (Jenny Strasburg): "Hedge-fund managers attracted $45.2 billion in the third quarter, a decline from record fundraising earlier in the year... New money gathered from investors worldwide fell by more than a fifth from $60 billion and $58.7 billion in the first and second quarters, respectively...Hedge Fund Research Inc. said... Returns averaged 1.36 percent in the third quarter, the smallest gain in a year, Hedge Fund Research said. Year-to-date inflows still surpassed the $126 billion record for all of 2006..."

Crude Liquidity Watch:

October 24 - Financial Times (Simeon Kerr): "Saudi Arabia is turning the home of one of its older industries into a symbol of what the kingdom hopes is its future. Thuwal on the Red Sea coast is a fishing port but, as part of a plan to end the kingdom's dependence on its petroleum-based economy, the government is turning it into the King Abdullah University for Science and Technology, or Kaust. The project, scheduled to open in 2009, will house up to 15,000 people, based around a graduate research-focused university. Kaust's mooted $10bn endowment, would make it one of the best funded universities in the world..."

Climate Watch:

October 23 - Bloomberg (Alex Morales): "Carbon dioxide is collecting in the atmosphere faster than forecast as the use of dirtier fuels increases worldwide, an Australian-led team of scientists said. Rising levels of the main gas blamed for climate change threatens to accelerate global warming, the researchers said. The study builds on previous findings and may lead to a change in the way scientists predict climate change."

Structured Finance Under Duress:

The market may be been perfectly content to brush it aside. It was, however, a brutal week for "contemporary finance." Merrill Lynch, a kingpin of structured Credit products, shocked the marketplace with a $7.9bn asset write-down - up significantly from the $4.5bn amount discussed just two weeks ago. Much of the write-off related to the company's CDO (collateralized debt obligations) portfolio, the size of which was reduced in half to $15.2bn during the quarter. But with proxy indices of subprime and CDO exposures down between 15% and 30% since the end of the quarter, Street analysts have already warned of the possibility for an additional $4bn hit. Merrill is not alone.

Also hit by sinking CDO fundamentals, Credit insurer Ambac Financial reported a third-quarter loss of $361 million - it's first-ever quarter of negative earnings. The company posted a $743 million markdown on its derivative exposures, "primarily the result of unfavorable market pricing of collateralized debt obligations." Credit insurance compatriot MBIA also reported its first loss ($36.6 million), on the back of a $352 million "mark-to-market" write-down of its "structured Credit derivatives portfolio." These two Credit insurance behemoths - and the "financial guarantor" industry generally - would have been a whole lot better off these days had they stuck to insuring municipal bonds and fought off the allure of easy ("writing flood insurance during a drought") profits guaranteeing Wall Street's endless array of new structured Credit products.

October 26 - Financial Times (Stacy-Marie Ishmael): "The perceived creditworthiness of two of the largest financial guarantors in the US on Thursday plunged to lows not seen since the worst of the credit squeeze in August. MBIA and Ambac are specialist companies that guarantee the repayment of bond principal and interest in the event of an issuer default - including bonds backed by subprime assets. After both companies this week reported third-quarter losses, investors have begun to speculate that the monolines, as they are known, might themselves in default on their outstanding debt. Spreads on five-year credit default swaps written on Ambac's debt widened by 50 bps to 300bp, according to Credit Derivatives Research... In other words, the annual cost of insuring a $10m portfolio of Ambac's debt over five years has risen by $50,000 to $300,000. The previous record of $238,000 was set on August 16..."

It is worth noting that MBIA and Ambac combine for about $1.9 Trillion of "net debt service outstanding" - the amount of debt securities and Credit instruments they have guaranteed, at least in part, to make scheduled payments in the event of default. Throw in the Trillions of Credit insurance written by the mortgage guarantors and you're talking real "money." Importantly, the marketplace is beginning to question the long-term viability of the Credit insurance industry, placing many Trillions of dollars of debt securities in potential market limbo.

With recent developments - including the monstrous write-down from Merrill Lynch, the implosion in the mortgage insurers, and the losses reported by the "financial guarantors" - in mind, I'll revisit an excerpt from a January article by the Financial Times' Gillian Tett: "...Total issuance of CDOs...reached $503bn worldwide last year, 64% up from the year before. Impressive stuff for an asset class that barely existed a decade ago. But that understates the growth. For JPMorgan's figures do not include all the private CDO deals that bankers are apparently engaged in too. Meanwhile, if you chuck index derivative portfolio numbers into the mix, the zeros get bigger: extrapolating from trends in the first nine months of last year, total CDO issuance was probably around $2,800bn last year, a threefold increase over 2005. These startling numbers will certainly not shake the world outside investment banking. For, as I noted in last week's column, the CDO explosion is occurring in a relatively opaque part of the financial system, beyond the sight - let alone control - of ordinary household investors, or politicians."

Subprime and the SIVs are peanuts these days in comparison to the gigantic global CDO and Credit derivatives markets. CDOs may lack transparency, trade infrequently, and operate outside of market pricing ("mark-to-model"). Nonetheless, CDO exposure now permeates the entire global financial system - exposure that regrettably mushroomed in the midst of the most reckless end-of-cycle mortgage excesses imaginable. Rumors this week had major insurance companies suffering huge CDO losses. To what extent the big insurance "conglomerates" have exposure to CDOs and other Credit derivatives is unclear today, but there is no doubt that the global leveraged speculating community is knee deep in the stuff. Importantly, as goes the U.S. mortgage market, so goes the CDOs. I'm not optimistic.

I don't want to place undue weight on one month's data, but the California statewide median home price sank $58,140 over the month of September (down 4.7% y-o-y to $530,830). This was by far the largest monthly decline on record and the first year-over-year fall "in more than 10 years." September California sales were down 39% from a year earlier. Weakness was statewide, led by a 63% y-o-y collapse in the "High Desert." But even San Francisco "Bay Area" sales dropped 46% y-o-y. Ominously, the California Association of Realtors "Unsold Inventory Index" surged to 16.6 months, almost double the level from just six months earlier and compared to 6.4 months in September '06. "The impact of the credit crunch spread throughout all tiers of the market in September," said California Association of Realtors Chief Economist Leslie Appleton-Young. As far as I'm concerned, there is sufficient evidence at this point suggesting the Great California Housing Bust has begun in earnest.

We've definitely reached a critical point worthy of the question: Can "structured finance," as we know it, survive the California and U.S. mortgage/housing busts? I don't believe so. For one, the historic nature of the Credit Bubble virtually ensures the collapse of the Credit insurance "industry" (companies, markets, and derivative counter-parties). The mortgage insurers are now in the fight for their lives, while the "financial guarantors" today face an implosion of their "structured Credit" insurance business. Worse yet, major problems in municipal finance (certainly including California state and municipalities) are festering and will emerge when the economy sinks into recession. It is worth noting that California revenues were $777 million short of expectations during the first fiscal quarter (see "CA Watch" above).

Returning to the vulnerable CDO market, some key dynamics are in play. With California now at the brink, uncertain but huge losses are in the pipeline for jumbo, "alt-A," and "option-ARM" mortgages - loans that were for the most part thought sound only weeks ago. The market began to revalue the top-rated CDO tranches this week, a process that should only accelerate. "AAA" is not going to mean much. If things unfold as I expect, a full-fledged run from California mortgage exposure could be in the offing. And as the dimensions of this debacle come into clearer market view, the viability of the Credit insurers will be cast further in doubt - with ramifications for Trillions of securities and derivatives. General Credit Availability would suffer mightily.

With global equities markets in melt-up mode, it might seem absurd to warn that a troubling global financial crisis is poised to worsen. But Structured Finance is Under Duress. The entire daisy-chain of liquidity agreements, securitization structures, Credit insurance and guarantees, derivatives counterparty exposures and, even, the GSEs is increasingly suspect. Trust has been broken and market confidence is not far behind.

The big global equities and commodities surge over the past few months certainly has been instrumental in counteracting what would have surely been a problematic "run" from the leveraged speculating community. How long this spectacle can divert attention from the unfolding mortgage/CDO/"structured finance" debacle is an open question. I can't think of a period when it has been more critical for stocks to rise - and rise they have. Yet I suspect recent developments will now encourage the more sophisticated players to begin reining in exposure.

The nightmare scenario - where the market abruptly comes to recognize that the leveraged speculating is hopelessly stuck in illiquid CDO, ABS, MBS, derivative and equities positions - doesn't seem all that outrageous or distant this week. Unfortunately, today's Ponzi-style acute fragility (as was demonstrated this summer in subprime, asset-backed CP, SIVs and the like) and speculative dynamics dictate that he who panics first panics best. I don't expect the sophisticated players to hang around and wait for securities to be properly priced and the full extent of illiquidity and the unfolding Credit debacle to be recognized. And while Bubbling markets do delay the inevitable reversal of speculative flows from the leveraged speculating community, they only compound the risk of an inevitable ravaging run from illiquidity. We'll see to what extent the Fed is willing to spur increasingly destabilizing global stock market speculation and dollar liquidation in false hope that lower rates can somehow mitigate Structured Finance Under Duress.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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