Today's Tidbits

Explosive Growth in Mortgage Debt Since Early 90’s Dwarfs Other Borrowing
From FTN: “The economy has been awash in liquidity since the late Nineties, keeping yields low, compressing spreads and generally forcing investors to settle for low returns. The favorite explanation for this super-abundance of liquidity is high Asian savings rates, especially in China, that created a surplus of investor capital searching for a home. But a case can be made that lax mortgage lending standards and Federal Reserve policy are responsible for creating a liquidity surge, which is simply the flipside of the housing bubble. Now, with housing in decline, the air is clearly coming out of the liquidity bubble, too. The vast majority of the debt created in the past ten years in the US was mortgage debt, most of which was financed domestically. (Yes, foreign buyers have stepped up mortgage buying in recent years, but still own just 11% of the total.) From 1992 through 2000, there was no acceleration in borrowing at all in the US aside from the acceleration in mortgage borrowing. There was some quarter-to-quarter variance, but the trend was steady at about $400bn a quarter at an annual rate. Mortgage borrowing, which had slowed to about $100bn at an annual rate in 1991, took off from that trough, rising to an $800bn pace in 2001. Through the Nineties expansion, mortgages filled the vacuum left
by the lack of growth of all other types of borrowing, especially by the Treasury once the budget turned to a surplus. But when other borrowing began to accelerate after the 2001 recession, mortgage borrowing never slowed down. Eventually, quarterly underwriting topped out in the third quarter of 2005 at an astonishing annualized rate of $1.65 trillion. In just ten years, total credit market borrowing in the US had tripled, with mortgage borrowing up tenfold and all other debt up just 75%. The biggest increases were in 2003 and 2004, when the Fed cut the fed funds rate to 1%. This was an irresistible environment for borrowers and lenders alike. Banks and mortgage companies were able to make secured loans at a decent spread above their cost of funds – something they will do all day long when given the opportunity – while borrowers were able to borrow at the lowest rates in modern history. Just how low rates were is astonishing in hindsight. If you add the tax savings from interest deductibility and the expected appreciation of house purchases in what was then a raging bull market for real estate, the real, tax-adjusted rate on ARM loans was deeply negative in the summer of 2004, -13.25% assuming a 25% marginal tax rate, and only rose above zero in September 2006, when house prices started to fall. The incentive to take a mortgage, not just to buy a house but to buy everything else, was tough to pass up. Rates were so low that mortgage equity withdrawal took off in addition to home purchases. Many homeowners thought they were “taking something off the table” by cashing in their capital gains. But they were not really taking profits at all, they were borrowing against an assumed future sale, and levering up in the process. That has left many with high loan-to-value ratios and increased sensitivity to home prices. Now, with home prices falling at a rate of about 1.5% a year and effective rates on adjustable rate mortgages above 6%, “real” tax-adjusted ARM rates are about 6%, a 12-year high. That’s not nearly low enough to lure in anyone that isn’t either refinancing out of a higher rate loan or buying for shelter. In fact, more than 80% of the loans underwritten this spring were fixed-rate loans, creating digestion problems that accounted for much of the back-up in long yields in May and June. Banks were perfectly happy to write adjustable mortgages at very low yields when their cost of funds was lower still. But they are not going to write an unlimited number of long-term fixed-rate loans in an inverted curve environment. Because of the backup, fixed rates are now higher than adjustable rates, slowing the pace of underwriting and shifting the borrowers back into ARMS. In the first quarter, borrowing in many sectors accelerated, but the rise was dwarfed by the drop in mortgage underwriting. As a result, the contraction of credit growth that began in the fourth quarter of 2005 continued…From an economic point of view, however, the most important aspect of the slowdown in credit is that the liquidity boom is over. Eventually, that means spreads will widen and asset price appreciation will slow and the curve will normalize. In the short-term, however, it means that in the second half, GDP growth is not likely to remain at the 3%+ expected in the second quarter.”

Analysts Expect Capital Expenditures to Drop Substantially This Year in US & EU
From The Financial Times: “The amount of capital that European and US companies are willing to spend on factories and equipment, the traditional engine of profit and economic growth, is set to plunge this year, according to business analysis. Capital expenditure as a percentage of profit before tax in Europe will fall from 64 per cent in 2006 to 55 per cent this year, according to a consensus forecast compiled by Thomson Financial, the data provider. In the US, the decline in the ratio is worse: spending is expected to fall from 51 per cent last year to 45 per cent in 2007. Historically, such dramatic declines would have triggered sharp falls in company profits. But this time economists have mixed views about the implications of these projections. Some say the forecasts are too pessimistic because analysts tend to underestimate capex, and investment has been revised up consistently in recent years. Moreover, companies have seen a profits explosion since 2003, which means the ratio of capex to earnings may look low because earnings are rising. Another factor is greater spending in emerging markets, where goods are less expensive… companies have been more focused on returning cash to shareholders by increasing buybacks and dividends in recent years, but are nevertheless still investing…. In the US, Goldman Sachs estimates that of the $1,600bn of funds companies have to spend this year, about 36 per cent will go on share buybacks; 33 per cent towards capex; 16 per cent on dividends; and 15 per cent for M&A.”

MISC

Treasury yields fell 3.5 -4.5 bp today, as investors sought safety following concerns about subprime problems expanding, after Bear Stearns put up only half the money they had pledged to support their hedge funds. The 10y Treasury yield is settling at 5.08%. After rallying over a hundred points in the morning, the Dow is closing down 8 points. The dollar index has closed unchanged. Concerns about maintaining refinery output put crude oil prices back in positive territory, after falling over a dollar in the morning, on news that a strike had been averted in Nigeria.

From Goldman Sachs: “Final domestic demand is softening noticeably as housing remains a big drag and both consumer spending growth and confidence have trended down recently. Moreover, financial conditions have begun to tighten, with our GSFCI up 40bp and as much as 60bp on an oil-adjusted basis since early May. Reflecting these trends, our estimates for final domestic demand growth are below 2% for both Q2 and Q3, which would in fact be slightly weaker than the mid-2006 period that triggered the initial inventory correction. Even if foreign trade remains a net positive -- as we expect -- this suggests that the risks are tilted toward a return to below-trend growth grates in late 2007 or early 2008.”From Bank of America: “Slowing growth in corporate tax receipts suggests slower corporate profit growth…”

From UBS: “The two week build in Fed Custody Holdings of Treasury and GSE debt of nearly $22B flies in the face of those who claim that foreign central banks have diversified away from Treasuries for good. Even though the slice of the foreign reserve manager's investment pie occupied by Treasuries may be thinning, it's also lengthening as the "pie" gets bigger. We see that the overall volume of overseas Treasury investments continues to expand-- which is important when squared against the cutbacks in new Treasury supply and the significant run-off of large maturing Treasury issues.”

From Deutsche Bank: “The gradual withdrawal of liquidity should continue, causing steeper curves and wider credit and swap spreads. Investor moves out of bonds and into money markets has richened the TED spread, and tightened repo rates. This could lead to swap spread widening further out the curve. Banks are unlikely to resume buying mortgages without a steeper yield curve. Narrower net interest margins and large negative OCI prevent banks from profitably adding mortgages to their balance sheet.”

From Morgan Stanley: “On the week, big gains at the front end and little change at the longer end left 2’s-10’s and 2’s-30’s [Treasuries] at their steepest levels since 2005, with the 2-year yield falling 12 bp to 4.92%, the 3-year 10 bp to 4.97%, the 5-year 8 bp to 5.02%, and the 10-year 2 bp to 5.14%, while the long bond held steady at 5.26%. The combination of disappearing supply and rising demand for cash kept yields at the very short end in freefall. After another 19 bp decline in the latest week, the 4-week bill yield has now plunged 71 bp in the past four weeks to just 4.24%.”

From JP Morgan: “Mexico vows to increase [corporate] tax collection…The package introduces a flat tax on factors of production, and it would require firms to pay taxes on whichever tax system—the new or old—yields the greater liability. The tax reform would lead to higher revenue by eliminating all exemptions. Moreover, the new tax package would favor investment and employment as it allows firms to fully offset capex and workers' compensation. However, with no exemption for interest payments, highly leveraged firms would be disadvantaged. Fiscal stimulus would be largely unchanged initially because the additional revenue would be spent on education and poverty alleviation. Some of the revenue would also be used to help fund the privatization of
the civil servants pension system.”

From Merrill Lynch: “The US economy has moved from the middle of the pack in 2006 to the end of the line in 2007; and the performance of the S&P 500 this year has hinged critically on owning sectors/companies with deep foreign exposure. Capital goods exports remain a source of strength The export boom is not just an Asian story, although US shipments to the region is up 10% year-on-year. But we also see that exports to the Pacific Rim have risen 13% and the leader is actually South America, which has taken in American-made goods at an impressive 17% pace in the past 12 months.”

From The Financial Times: “Fertilizer production is undergoing a significant structural change as production facilities increasingly move from regions such as the US, Europe and former Warsaw Pact countries…where [natural] gas prices are high, to areas where gas prices are low because of local supply…increasingly moving to the Middle East …High gas prices, rising global demand for agricultural products because of population increase, and burgeoning demand for biofuels have resulted in a booming market for fertilizer around the world…Algeria has the third largest reserves of natural gas in the world.”

From Bloomberg: “A mystery malady that's killing U.S. honeybees has also been found in Europe, Asia and South America, raising the possibility of global colony collapse… Die-offs in bees used commercially to pollinate almonds, apples and oranges may eventually affect production of U.S. crops valued at $14.6 billion, according to the Department of Agriculture. U.S. crop production so far has not been harmed partly because of bee imports. Global collapse would curtail that option… The disorder, which killed up to 90 percent of the bees in some U.S. hives last winter, has been found in 35 states and one Canadian province…” [Another factor that could push up food prices]