Today's Tidbits

Impact of a Weaker Dollar and Inflation
From The Wall Street Journal: “Robust growth outside of the U.S. means robust demand for goods globally. That helps the overseas sales of multinationals but could also push up prices at home for globally traded goods. While the U.S. economy lumbered in the first quarter, China’s GDP was 11.1% above its year-ago level, which means that China’s appetite for raw materials has only grown. Now throw the dollar in the mix. With the rest of the world growing faster relative to the U.S., the rest of the world has become a more attractive place to invest – on reason the dollar is weak. On a trade-weighted basis, the dollar has hit its lowest level against the currencies of major U.S. trading partners in the 36 year the Federal Reserve has been keeping records. That means that the dollar’s buying power has been reduced compared with other currencies. Profits earned abroad translate into more dollars at home, but it also means it costs more to import products. Consider gold, often seen as an inflation gauge. At $678.70 an ounce, it has risen 13% over the past six months and is just 6% shy of the…high it hit last May. But in euro terms, it has risen just 6% over the past six months, and the May peak is 13% away…In March, prices for imported consumer goods, excluding automobiles, were 1.8% higher than they were a year earlier – the biggest gain in 11 years…The risk is that this could make it harder for the Fed to cut rates in the presence of economic weakness.”

Growth of Islamic Banking
From Bloomberg: “Shariah requires that investors profit only from transactions based on the exchange of assets, not money alone, so interest is banned. Bankers sell Islamic bonds, or sukuk, by using property and other assets to generate income equivalent to interest they would pay on conventional debt. The money can't be used to finance gambling, guns or alcohol. The world's top five banks by assets -- Zurich-based UBS AG, HSBC and Barclays Plc in London, Paris-based BNP Paribas SA and Citigroup in New York -- have Islamic units. CIMB Group Bhd. in Kuala Lumpur is the biggest underwriter of sukuk this year followed by Standard Chartered in London, Barclays and Citigroup, Bloomberg data show. Sales of sukuk grew nine times faster than international corporate bonds last year and twice as fast as the U.S. market for debt with ratings below investment grade, according to Bloomberg data…The Shariah finance industry, born in the 1970s after a 12- fold jump in oil prices, is expanding with crude prices near record highs enriching Islamic nations.”

Bank of England Report Says Liquidity Higher Now than in Dotcom Bubble of ‘99
From The Economist: “The Bank uses three measures. The first is the bid-offer spread—the difference between the prices at which market makers are willing to buy and sell securities. The smaller this spread, the more liquid markets have become. The second measure captures the effect of trades on asset prices—in illiquid markets, those who want to deal in size can find that prices move against them. This factor can be quantified as the ratio of price movements to trading volumes; a lower ratio means markets are more liquid.
The final measure is based on the corporate-bond market. Historically, such bonds have offered a higher spread over government securities than would be justified by investors' losses during defaults. This is probably because investors have demanded a premium for owning an illiquid asset. Any shrinking of this premium may suggest markets have become more liquid. The Bank has combined these measures into a composite ratio. From about 2004 onwards, this ratio moved to a much higher level, suggesting it is now very easy to buy financial assets. Another way of looking at it is to say that the cost of trading is very low. Why might this be? One obvious possibility is the activity of hedge funds, which turn their portfolios over rapidly, making it easier for other market participants to deal. Hedge-fund assets have grown fast over the past decade and now are at least $1.5 trillion. Another factor may have been that investment banks have devoted more energy and capital to trading in financial markets. Financial innovation has also helped; the creation of the credit-derivatives markets has encouraged investors to buy corporate bonds, since they can now unbundle the various risks and trade them separately. That has driven down the liquidity premium in the bond market (and pushed yields lower). This may not be permanent. Liquidity is a self-reinforcing process; investors are more willing to buy an asset they know they can sell easily. But if liquidity suddenly dries up, some investors might end up owning assets they neither want nor can get rid of. That might make a virtuous circle turn vicious.”

Investor’s Indiscriminate Demand For High Returns Increased Subprime Issuance
From Bloomberg: “Demand for bonds, and investors' complacency toward risk, can be blamed for the record early delinquencies and defaults on subprime home loans, speakers at an industry conference in Miami said. The poor performance of subprime home loans made last year stems from an average drop of at least 0.50 percentage point in the yield premiums for credit risk on all types of fixed-income assets since 2000, Mortgage Bankers Association Chief Economist Doug Duncan said, citing research by other economists. ``That allowed another cohort of borrowers to get into homes that wouldn't have if credit spreads were wider,'' Duncan said yesterday, citing cheaper loans and looser underwriting. Investors, seeing ``clear signs'' that subprime home loans had gotten too risky, didn't pull back from the securities because of the ``increased global liquidity and increased quest for yield,''…The U.S. bond market has been flooded with money first transferred overseas to China, oil-producing countries and other nations through trade deficits, said David Wyss, chief economist at New York-based Standard & Poor's. Their higher savings rates, he said, means the cash returns to the world bond markets. U.S. bonds have been attractive because of higher yields on government debt, and because the nation has the ``only large and liquid private bond market,'' which offers even greater yields, Wyss said in an interview. Of the $1.1 trillion in foreign investments in the U.S. last year, 89 percent went into bonds, Wyss said, citing Treasury Department data…Any talk of blame misses the ``shared responsibility'' said Christensen [of Fair Isaac]. ``You don't have lenders lending unless you have someone willing to purchase it and someone willing to rate it.''…[others] disagreed. ``I think it's the investors that have been screwing up'' by relying too much on the credit ratings of firms like S&P and Moody's.”

Is Private Equity The Next Bubble to Burst?
From The Boston Globe: “Debt markets that finance private equity transactions have changed in three important ways. They are charging lower interest rates, reducing the premium normally charged for greater risk. They are lending more money for the purchase of an operating company, exceeding normal caps based on the cash generated by the acquired business. Finally, debt markets are reducing or virtually eliminating covenants and other rules that now make it almost impossible for private equity investors to default on loans used to buy companies. Got that? Low rates, more leverage, practically no conditions. How do you think that story is going to end? "The reality is the markets are willing to provide extraordinary amounts of debt, almost indiscriminately," says …the big Boston private equity firm. "It's hard to put these companies into default. I can't think of the last time we had a real covenant in one of our deals."”

New Century Financial Misused Gain-on-Sale Accounting Rules for Mortgages
The New York Times: “In the spring of 1998, the chief financial officer of New Century Financial, a lender to home buyers with blemished credit, wrote an unusual paper describing a then little-known accounting technique…Now that technique, called gain on sale, may be coming back to haunt the company, which filed for bankruptcy protection on April 2 after disclosing a month earlier that federal prosecutors and securities regulators were investigating accounting mistakes and stock sales at the company….The technique …allowed the company to report profits before they actually existed. The paper profits were pegged to future earnings from loan sales to institutional investors. The results, which were nearly always prettier than those produced through traditional, conservative accounting in which profits were recorded only when cash comes through door, were then used to make more loans to risky home buyers. Used properly, gain on sale is legal. Big investment banks routinely employ the technique when packaging securities for sale to institutional investors. Unlike specialty finance lenders like New Century, though, Wall Street banks have deep pockets to support themselves if expected earnings from gain on sale accounting fail to materialize.
But some financial analysts say that New Century appears to have also used gain on sale to hide losses as the subprime market began to falter late last year…The use of gain on sale was a factor in the collapse of Enron in 2001 and of major specialty lenders in the late 1990s through this decade…The deterioration in recent months of the estimated $1.3 trillion subprime housing market has been tied to rising loan delinquencies and the decision by Wall Street to cut off billion-dollar credit lines to companies like New Century, which last year was the largest independent player in the industry…the stock prices of subprime home lenders like New Century Financial had “collapsed so fast because the income and balance sheet had been built on gain on sale, which turns out to be imaginary.”… New Century, of Irvine, Calif., made money in two ways, and it used gain on sale for both. In the first way, called “whole loan sales,” it sold pools of loans to big Wall Street investment banks. New Century made money by keeping the difference between the higher interest rates paid by subprime borrowers and the lower rates offered to the banks. In the second way, New Century chopped up its other loans to home buyers, repackaged them into securities for sale to investors, a process called securitization. New Century then kept the pieces expected to earn money in the future, called residuals, for itself. For both types of business, gain on sale allowed New Century to accelerate its profits. In 2005, the last year for which it has reported annual figures, New Century recorded income from gain on sale accounting of nearly $623 million out of a gross profit that year of $1.4 billion, according to its securities filings. For the whole loan sales, New Century recorded up front the cash gains. At the same time, New Century guaranteed to Wall Street investors that if the whole loans did not make as much money as it predicted — if home buyers were late with or defaulted on payments — New Century would buy back the impaired loans from the banks. But through overly rosy forecasts, New Century underestimated how many impaired loans it would have to repurchase and how much it would need to have on hand to do that. In its second use of gain on sale, New Century booked future earnings based on its estimates of what it expected to earn from the pieces left over from the securitizations. New Century’s problem, according to Zach Gast, an analyst with the Center for Financial Research and Analysis, was how it used gain on sale for its whole loan business. In the late 1990s, in the last downturn for subprime lenders, most abuses of gain on sale involved the securitization side. At New Century Financial, “it was aggressive accounting, that is certain,” Mr. Gast said. “But there are hints that New Century knew exactly how aggressive it was.” As the subprime market started to melt down last fall, New Century was forced to honor its guarantees to investment banks and other institutional investors and repurchase the impaired loans. It resold the loans at a loss. But, Mr. Gast said, when New Century repurchased the loans, it recorded them at values that exceeded the fire-sale prices. In other words, New Century did not recognize upfront the losses in the impaired loans. Mr. Gast said that New Century has “a huge number of repurchased loans that they haven’t taken losses on.” Under gain on sale accounting rules, “you should be recognizing the loss at the initial sale of the loan,” Mr. Gast said, adding that if you underestimate potential losses, you have to recognize those losses when you are forced to repurchase the loans — something New Century did not do.”

Emerging Market Debt Increasingly In Local Currencies as Economies Improve
From Merrill Lynch: “In the last 10 years supply and demand for local debt markets (LDM) increased exponentially. Supply increased because emerging market officials have been reducing foreign liabilities and replacing them with domestic bonds. Demand increased because inflation has been converging and investors continue to seek alternative investment opportunities…According to the BIS, the total stock of emerging market debt reached USD5.5tn in 2006, of which 17% is external debt and 83% is domestic debt. The change in the debt profile, to favor LDM, reflects the effort of both sovereigns and corporates to reduce their foreign currency liabilities. LDM were also boosted by the improvement in economic fundamentals in the individual countries.”

MISC
From Dow Jones: “U.S. Treasuries lost ground [as interest rates rose 1-3bp and the curve flattened]… The dollar stayed firm after the Fed’s Bernanke said that real interest rate remain “very, very low” and brushed off concerns that outsourcing is a major threat to the US economy…[Equities closed higher with the Dow up 73]… Crude oil futures were slightly lower in choppy trading…”

From Morgan Stanley: “S&P 500 outperformed all asset classes on a weekly, MTD, and 52-week basis with 0.9%, 4.9% and 5.3% returns, respectively. However, on a YTD basis, commodities have outperformed all asset classes.”

From The Dallas Morning News: “Centex profit is down 50 percent for quarter…CEO says it's 'one of the most difficult markets in 25 years'”

From Goldman Sachs: “The BOJ’s growth and inflation outlook in the BOJ’s FY2007-08 Outlook report appeared to be cautious. The seemingly cautious growth and inflation outlook, however, can be viewed as the BOJ’s tactics to enable earlier rate hike by lowering the market’s sights on them. We believe the BOJ is more wary about asset price appreciation than it has indicated in public statements. There is a growing likelihood that the BOJ may move forward the timing of its next rate hike to July…”

From Merrill Lynch: “The ISM defied expectations and surged 3.8 points in April to 54.7, the highest level in eleven months…When you get 75% of the regions report a decline in activity and then get a 3.8 point pop in the national index then you know you have a story because this is the first time that has ever happened. Just to see a 3.8 point surge is a big deal on its own because in the past decade, it has only done this 4% of the time - a 1 in 25 event; and usually it occurs after an event that took the prior month down sharply (i.e. Katrina, 9-11, Sarbanes-Oxley). But the data clearly suggest, as a stand alone event, and assuming that the ISM was "right" while the majority of the regional indices were "wrong", that capex is starting off the current quarter on a much better footing than it started Q1…”

From Morgan Stanley: “The amount of Fed easing priced into futures markets contracted modestly to around 40bp of cuts by year-end, compared to two full cuts previously.”

From Lehman: “[In today’s ISM report] 20 commodities were reported “up in price” with no commodities reported as “down in price.” Of these 20, half have not been trending higher (they appeared on the list in April but not in March).”

From Bloomberg: “Manufacturing activity in China expanded at the fastest pace in more than two years in April, according to a survey of purchasing managers released today.”

From Citi: “…consumer spending numbers are beginning to show mild stress as
Rebook Retail Sales printed sharply down with its first negative reading since
March of 2003.”

From Morgan Stanley: “Based on a nearly complete count, we estimate that motor vehicle sales held steady at 16.3 million units annualized in April. This was as expected overall, though the mix was more positive, with sales of domestically produced vehicles rising to an estimated 12.6 million from 12.3 million and imports dipping to 3.8 from 3.9.”

From Reuters: “President Hugo Chavez's government took over Venezuela's last remaining privately run oil fields Tuesday, intensifying a decisive struggle with Big Oil over one of the world's most lucrative deposits…three-quarters of the world's proven reserves are already controlled by state monopolies…”
From The Bureau of Economic Analysis: “For the first time, the Department of the Treasury will release quarterly transactions data and yearend investment position data on financial derivatives… The data on financial derivatives will be included on new line items in BEA’s standard tables. In future releases of the balance of payments, BEA will incorporate quarterly derivatives transactions data on the newly established line item with a one quarter lag…. The quarterly balance of payments table presents U.S. transactions in financial derivatives on a net basis on a new line. The annual international investment position table will separately present gross positive and gross negative positions in derivatives, as this level of detail is available from the new source data.”
From Bloomberg: “Business students are more likely to cut corners than those in any other academic discipline, several studies show. A Rutgers University survey last year found that cheating at business schools is common, even after ethics courses were added following scandals that bankrupted Enron Corp. and WorldCom Inc…56 percent of those in business schools acknowledge violating the rules.”