August 20, 2007 TIDBITS

Evolution of a Credit Crunch
From HSBC: “The financial system is suffering a seizure. The good news is that central banks appear willing to act, adding liquidity and, in the Fed’s case, cutting the discount rate. The bad news is that the seizure may not respond swiftly or easily to changes in monetary policy. The seizure reflects a loss of faith in subprime mortgages and collateralised debt obligations and a loss of faith, also, in the institutions that have invested in these products. Most of us thought weak US housing would be a problem for debt-laden households. Increasingly, though, it’s the creditors who are having difficulties. The seizure is a capital market problem. Central bank actions so far are designed to guarantee additional liquidity to the commercial banks, whether through injections of cash or through reductions in discount rates. However, the crunch is occurring in the non-bank financial sector, and the commercial banks are increasingly wary of extending liquidity to these institutions. The central banks may be able to control the price of money, but at the moment it’s quantity that counts…The financial market turmoil is best understood with reference to the Manias, Panics and Crashes2 so well described by the late Charles Kindleberger. The past few weeks have revealed a crisis that is linked to the US housing market. The crisis, though, is not for the debtors (i.e. the households). Instead, the problem lies with the creditors. This, therefore, is not so much the wealth effect of old, constraining household spending, but rather a credit crunch problem. It is a problem that lies at the heart of the financial system. The good news is that other parts of the economy – in particular, the corporate sector with its excellent balance sheet position – will not be affected for now. Companies are likely to find themselves in trouble only in the light of a major collapse in demand…The roots of the problem are three-fold. First, the Federal Reserve left monetary conditions too loose for too long in the early years of this decade, helping to trigger a housing boom. Second, emerging market reserve managers invested their mammoth reserves in safe assets, placing downward pressure on yields and forcing other investors to take more risk to achieve desired returns. Third, housing-related innovations in financial products acted as a magnet for the resulting “excess liquidity”. These products – the alphabet soup of modern finance – include CDOs, ABS, MBS and asset-backed commercial paper…The fire-sale of equities in recent weeks, for example, can only be understood in this context. The latest crisis has historical precedents. If, as seems likely, there is a credit squeeze, the comparable periods include the aftermaths of the late 1980s Savings and Loans crisis, the 1998 LTCM crisis and the 2000 NASDAQ crash. However, the outcomes from these episodes varied hugely.”

Poor Regulatory Oversight Leaves Market Unsure Where Problems Lie
From Bill Gross: “Those looking for clues to the extent of the spreading fungus should understand that there really is no comprehensive data to allow anyone to know how many subprimes actually rest in individual institutional portfolios. Regulators have been absent from the game, and information release has been left in the hands of individual institutions…Also many institutions, including pension funds and insurance companies, argue that accounting rules allow them to mark subprime derivatives at cost. Default exposure, therefore, can hibernate for many months before its true value is revealed to investors and, importantly, to other lenders. The significance of proper disclosure is, in effect, the key to the current crisis. Financial institutions lend trillions of dollars…The food chain in this case is not one of predator feasting on prey, but a symbiotic credit extension, always for profit, but never without trust and belief that their money will be repaid upon contractual demand. When no one really knows where and how many Waldos there are, the trust breaks down, and money is figuratively stuffed in Wall Street and London mattresses as opposed to extended into the increasingly desperate hands of hedge funds and similarly levered financial conduits. These structures in turn are experiencing runs from depositors and lenders exposed to asset price declines of unexpected proportions. In such an environment, markets become incredibly volatile as more and more financial institutions reach their risk limits at the same time. Waldo morphs and becomes a man with a thousand faces. All assets, with the exception of U.S. Treasuries, look suspiciously like one another. They're all Waldos now. The past few weeks have exposed a giant crack in modern financial architecture, created by youthful wizards and endorsed for its diversity by central bankers present and past. While the newborn derivatives may hedge individual institutional and sector risk, they cannot eliminate the Waldos. In fact, the inherent leverage that accompanies derivative creation may foster systemic risk when information is unavailable or delayed in its release. Nothing within the current marketplace allows for the hedging of liquidity risk, and that is the problem at the moment. Only the central banks can solve this puzzle, with their own liquidity infusions and perhaps a series of rate cuts. The markets stand by with apprehension.”

High Priced Home Markets Under Attack Too
From Fortune: “Not only has the [subprime mortgage] collapse driven up rates on many kinds of mortgages, but fear of a stock crash -- one perhaps sparked by the bursting of the credit bubble -- has for now prompted many high-end homebuyers to either trim their offers or stop shopping altogether...For years jumbo rates were only 0.25 of a percentage point above those of "conforming" loans -- those below the cutoff (now $417,000). In recent weeks that spread has exploded to 0.75 of a percentage point or more. BankRate.com reports that the average tariff on jumbo loans soared to 7.35% nationally in August, and many mortgage brokers are reporting figures that exceed 8%. Increased rates on big home loans translate to a substantial decline in buying power. Two years ago a $6,000 monthly payment would support a $1 million, 30-year mortgage at 6%. Today that same $6,000 payment covers only an $870,000 mortgage at 7.35%. In other words, higher rates have trimmed the buying power of luxury-home buyers by 10% to 15%. Throw in the fact that some buyers can't get a mortgage at any rate right now, and you've got all the makings for a national price correction for luxury homes… One top mortgage fund manager says he's sworn off investing in jumbos because he doesn't trust the rating agencies to distinguish the good credit from the bad.”
From RGSGC: “A separate issue whispered about is how the last few weeks will impact Wall Street's bonuses and employment. The point here is that the higher end of the earnings spectrum may feel the pinch that the lower end has already been feeling -- it's the Tiffany vs. Wal-Mart reconciliation.”


Why Banks Might Want to Fund Through Discount Window
From Morgan Stanley: “…if a bank can borrow at 5.25% on an unsecured basis in the fed funds market, why would they go to the discount window for 5.75%? My response stressed the certainty of a 30-day term, renewable by the borrower, in an environment in which the fed funds market was very volatile, as well as the counter party risk inherent in the fed funds market. But, here is an excerpt from a Q&A with Lou Crandall of Wrightson Assoc, appearing on Greg Ip's blog, that comes at it from a slightly different angle that I find pretty compelling. Q: Why might a bank take out a discount loan, under these new terms, instead of borrow fed funds? A: Credit line limits. Fed funds are a bilateral market, and each bank puts a limit on its trading line with every other participant. (Those limits are sometimes effectively zero – that is, the credit department of a bank may choose to monitor only a certain number of participants). Moreover, the credit lines in fed funds are not commitments, they are discretionary caps. Bank A is not required to lend up to its own self-determined limit to Bank B. Rather, the limit is the max that its traders can do, and they (or the credit department) can choose to lower their exposure at any time. Banks tend to assume that their access to funding will dry up in a crisis, and so are reluctant to make commitments that can only be met that way. The Fed’s statement noted that the new primary credit terms would give banks “assurance” of funding, or wording to that effect. I think the biggest point here is that banks can now make a commitment to, say, a commercial paper issuer whose assets they consider sound, to provide funding knowing that the window is available even if a bank’s own market access dries up. I think the Fed wants to make sure that banks’ decisions about lending are based only on traditional asset-side risk (credit risk and interest-rate risk) and not on banks’ own liquidity risk.”

Schedule of ARM Resets and Likely Default Rates
From Lehman: “With more than $120-$140 billion of mortgages expected to reset every quarter for the next five quarters, reset volumes will peak to historically high levels. The vast majority—more than 80%—of these resets are from subprime 2/28s originated in 2005 and 2006, notorious for their weak underwriting. The comparatively few agency and prime borrowers resetting in the coming months are from the 2003 and 2004 vintages. In addition to sound underwriting, these prime resets have seen stronger HPA. The bulk of the prime ARM universe is scheduled to reset in 2010 and beyond. There are about $30 billion per month in ARMs coming up for reset from the subprime market alone. We expect loan originations in the subprime space to run at $10 billion a month. Even if all the subprime ARM borrowers wanted to refinance, 60% of them are likely to be denied credit under current market conditions. About 40% of the resetting borrowers would not have been able to refinance their mortgages at their original terms even before the liquidity seizure in the markets. If market conditions were to revert to the May-June period, we think aggregate defaults in the next 24 months will be about $240 billion. This represents approximately 950,000 homes going through the foreclosure process. We project lifetime defaults of $584 billion and 2.3 million homes going through foreclosure in this scenario. In the extreme case that market conditions do not revert back,
we think defaults could total as much as $733 billion in aggregate and an additional 500,000 of homes would go through the foreclosure process by December 2008. The additional increase in defaults represents approximately one month of existing home sales.”

I.R.S. Always Wants It’s Cut, Even in Default
From The New York Times: “Two years ago, William Stout lost his home in Allentown, Pa., to foreclosure when he could no longer make the payments on his $106,000 mortgage. Wells Fargo offered the two-bedroom house for sale on the courthouse steps. No bidders came forward. So Wells Fargo bought it for $1, county records show. Despite the setback, Mr. Stout was relieved that his debt was wiped clean and he could make a new start…But on July 9, they received a bill from the Internal Revenue Service for $34,603 in back taxes. The letter explained that the debt canceled by Wells Fargo upon foreclosure was subject to income taxes, as well as penalties and late fees. The couple had a month to challenge the charges… losing one’s home can feel like hitting bottom. But one more financial indignity may await as the fallout from the great housing boom ripples across the United States… Notices of unpaid taxes, unanticipated and little understood, will probably multiply as more people fall behind on their mortgages… Foreclosure is one way that beleaguered homeowners can fall into this tax trap. The other is when homeowners are forced to sell their homes for less than the value of the mortgage. If the lender forgives that difference, they are liable for income taxes on that amount. The 1099 shortfall, as it is called, stems from an Internal Revenue Service policy that treats forgiven debt of all types as income even if the taxpayer has nothing tangible to show for it, unless the debt is canceled through bankruptcy.”





Money Market Funds Invested in Risky CDO’s – Too Much Reliance on Ratings
From Bloomberg: “Money market funds were invented 37 years ago to offer investors better returns than bank savings accounts while providing a high degree of safety. Most of the $2.5 trillion sitting in these funds is invested in such assets as U.S. Treasury bills, certificates of deposit and short-term commercial debt. Unlike bank accounts, money market funds aren't insured by the federal government. They almost never fail. Unbeknownst to most investors, some of the largest money market funds today are putting part of their cash into one of the riskiest debt investments in the world: collateralized debt obligations backed by subprime mortgage loans. CDOs are packages of bonds and loans, and almost half of all CDOs sold in the U.S. in 2006 contained subprime debt, according to a March report by Moody's Investors Service…Under SEC rules, money market managers must invest in securities with ``minimal credit risks.'… Money market funds have become a staple for investors. There are 38.4 million money market fund accounts in the U.S….Investors have sought safety during the subprime meltdown by moving their holdings to U.S. Treasuries and money market funds. On Aug. 8, just after the Bear Stearns hedge funds filed for bankruptcy protection, U.S. money market fund total assets reached a record high of $2.66 trillion, with investors pouring
$49 billion into such funds in one week, according to the ICI. As a sign of stability, money market funds never allow their share price to rise above or fall under $1 for each dollar invested. A money market fund that invests in subprime debt increases the risk that its share price could drop below $1. If 5 percent of a fund's holding is subprime debt, and in a worst-case situation that asset collapses, then the value of the fund could drop to 95 cents… ``Fund companies will support the funds,'' he says. ``They won't let them break $1 a share. The odds of money market funds breaking the buck are virtually nil.'' Just once has a money market fund failed. In 1994, a fund run by Community Bankers Mutual Fund of Denver invested in securities that defaulted. Investors were paid 96 cents a share, and the fund was liquidated…Commercial paper pays relatively low interest rates, which averaged about 5.3 percent in June and July, because it rarely defaults…CDO commercial paper, often loaded with subprime debt, pays higher returns than corporate paper, and it paid as much as 6.5 percent in August… Money market managers buy CDO commercial paper even when prospectuses warn of the risks. Zurich-based Credit Suisse, Morgan Stanley in New York and San Francisco-based Wells Fargo are among money market managers that poured more than $1 billion into commercial paper …``Reliable sources of statistical information do not exist with respect to the default rates for many of the types of collateral debt securities eligible to be purchased by the Issuer,'' say both the 2005 and 2006 CDO prospectuses backing commercial paper held in the funds…Tim Wilson, head of Credit Suisse's cash management portfolio desk, says he's comfortable with CDO commercial paper because it has the highest credit ratings and because his funds hold the debt for only one to three months. ``We don't have any concerns these are going to have any defaults in 90 days,'' he says. ``We're obviously watching.'' The paper matures within three months, and after that the fund doesn't hold any subprime debt, unless Wilson decides to buy more. Vanguard Group Inc., the second-largest mutual fund company in the U.S., has a policy of never buying CDO commercial paper for its $90 billion in money market funds or $325 billion in fixed-income mutual funds. ``It really gets down to transparency questions,'' says John Hollyer, risk management director at Valley Forge, Pennsylvania-based Vanguard. ``Can you understand what you have?
And can you measure it appropriately? We haven't been comfortable that we could.'' Bank of New York Mellon Corp.'s Dreyfus unit has banned CDO commercial paper from its $110 billion in money market funds because it has found that analyzing subprime holdings in CDOs is too difficult. The firm's money market investment committee decided in 2005 that such paper was too risky… Most of the dollar value of all CDOs, as much as 90 percent, gets a credit rating of AAA or Aaa. The higher the credit rating, the lower the return that's demanded by investors. The CDO commercial paper bought by money market funds always has a top credit rating, even when it's backed by subprime debt. In the past three years, Fitch, Moody's and S&P have made more money from evaluating structured finance -- which includes CDOs and asset-backed securities -- than from rating anything else, including corporate or municipal bonds, according to their
financial reports. The companies charge as much as three times more to rate CDOs than to analyze bonds, their cost listings show. The three rating companies say these fees are higher because CDOs are so complex. The close working relationships between CDO managers and rating companies -- and the fees that change hands -- mean money market funds shouldn't rely on ratings to evaluate CDOs, says Harvey Pitt, who was SEC chairman from 2001 to 2003. Pitt says fund managers should do their own research on
CDOs by reading the hundreds of pages of prospectuses and the monthly trustee reports. Some managers may not have been doing their homework. ``Relying on rating agencies for investment advice is dicey,'' he says. ``Their reliance on rating agencies left them
a day late and several dollars short.''…Fidelity Investments, the world's biggest mutual fund company, owned $2.3 billion in CDO-issued commercial paper in two money market funds as of May 31…The biggest money market fund in the U.S., Fidelity Cash Reserves Fund, had 1.5 percent of its $98.2 billion assets invested in CDO commercial paper backed by subprime debt. The Fidelity Institutional Money Market Portfolio had 2.3 percent of its $32.3 billion in assets in such commercial paper. Boston-based Fidelity fund manager Kim Miller says he's holding off on buying more CDO debt…. Money market managers are required to determine that their investments are safe and have high credit ratings, according to Rule 2a-7, a 1997 addition to the Investment Company Act of
1940. ``The money market fund shall limit its portfolio investments to those United States dollar-denominated securities that the fund's board of directors determines present minimal credit risks,'' the rule says…The subprime-backed commercial paper in money market funds offers some of the highest yields managers can include in their investments because such funds are prohibited by SEC rules from buying junk-rated debt. The Bear Stearns hedge fund implosion demonstrated how misleading credit ratings of CDOs can be… While CDOs aren't regulated by the SEC, mutual funds -- including money markets -- are. The SEC disclosed in June it's begun looking at some CDO investments, without releasing further details…Investors are accustomed to treating money market funds as
if they were bank savings accounts. The last thing they expect is that the subprime debt turmoil would enter their safe cash havens. And now it has.”

MISC

From JP Morgan: “…the Fed now is expected to trim the funds rate 25bp at both the September and October FOMC meetings. This action is expected to bolster financial markets and limit the slowdown in US GDP growth to a trend-like 2.5% pace over the three quarters through 1Q08.”

From Morgan Stanley: “Higher volatility is here to stay, and the threat to earnings and volatility means there is still more risk in equities and credit. Yield curves likely will steepen by more, and depending on risk appetite, the dollar may continue to weaken.”

From RGSGC: “[Tomorrow] 10am closed-door meeting with Bernanke, Paulson, and Sen. Dodd -- Chairman of the Senate Banking Committee. To discuss responses to "ongoing turmoil". Senator Dodd then speaks at 11 am post-meeting to discuss recent developments.”

From RBSGC: “With quarter end approaching for several firms this month and with, we presume, hedge funds having redemption issues a bounce in collateralized debt areas will be deemed a chance to pare back exposure, not extend.”

From MNI: “The [Chinese] government has permitted individuals to invest directly in an overseas stock market for the first time, with a trial program allowing individuals to start trading securities on the Hong Kong Stock Exchange, according to the State Administration of Foreign Exchange. Under the trial program, domestic investors can invest foreign exchanges already in their possession or purchase them, outside the current quota of 50,000 usd of foreign exchange that individuals are allowed every year.”

From Bloomberg: “SunTrust Banks Inc., seeking to cut $530 million in annual costs by 2009, expects to eliminate about 7 percent (2,400 employees) of its workforce by the end of next year as profit from retail and commercial banking declines.”

From Barclays: “Equity vol continues to come off: VIX traded at 37+ on Thursday.. currently 28 which is down 2 on the day. Appears the broader equity mkt is not super worried about the economy collapsing and stocks crashing. This is about credit, and the ability of some firms (non-banks) to finance. The huge drop in Bill rates must
mean that money is just flowing out of money mkt funds into bills/cash instruments.”

From Morgan Stanley: “Tighter financial conditions imply downside risks to global growth for now…The US is most at risk, but global spillover effects matter; this shock is economic decoupling's first real test. There are downside risks in commodities, and this shock is disinflationary, giving central banks latitude to respond to growth threats…. Global softening is in the price, but global recession is not. Therefore, near-term weakness in US consumer spending could ignite fears of global economic contagion… Investors should not lose sight of the global economy's underlying resilience, which could play an important role in reversing the downside risks for markets.”

End-of-Day Market Update

From RBSGC: “The market was well bid on Monday in a continuation of the credit/liquidity concerns that have driven Treasuries to these levels and have held us here. Today's data was a non-event, a consensus uptick in Leading Indicators did nothing but clear the way for more buying as Treasuries moved higher on the weakness in equities. Despite the afternoon recovery in stocks, yields stayed low, with 2s staying closer to 4% than we have seen in recent weeks while 10s hover near 4.61% -- an important level. The beginning of this week has brought with it more credit-related jitters as the Commercial Paper continues to show signs of stress. The theme in short-dated corporate debt remains limited liquidity for second-tier credit borrowers and obligations beyond 2-weeks. While the concerns surrounding near-term liquidity have been addressed (at least temporarily) by the Fed, there remains an overarching concern that these measures will prove insufficient. The bill market has been one of the biggest benefactors of the risk aversion trade -- with the benchmark 1-month T-Bill (9/13/07) yielding just 2.21% -- vs. a 3.14% close last Thursday -- impressive demand for the sector by any measure. This bid for quality has not gone unnoticed at the NY Fed, which announced that it will redeem $5 bn of its maturing holdings on Thursday -- bring the cash onto its balance sheet to help in overnight operations and fund the demand for money at the Discount Window -- currently the two most meaningful ways of addressing the credit crunch… Volumes were modest… Current levels are hardly screaming buys. We are concerned with the front end in particularly given just how aggressive it's been in pricing in easing and are reminded that 125 bp through funds is normal into that first ease which means inside 4% 2s are fair, not cheap. And while the market won't argue with a 50 bp rate cut over the next few weeks -- at the least -- the steps the Fed has taken so far are incremental and you cannot divorce market expectations from Fed reality. If Monday's action is any guide, while liquidity is certainly a continuing issue the frozen panic of the prior week has calmed somewhat. Everyone is in something of a waiting mode.”

From SunTrust: “The lack of liquidity in spread products has moved into Treasuries. The short bill market is off the charts. The 3 month bill opened at a 3.80, dropped to 2.50, then back to 2.90. The move reportedly started with a large purchase by a central bank in the w.i. three month. Then continued angst in the commercial paper market forced more investors, including money market funds, into the bill market. The bill auction was a complete disaster. The three month tailed back 20 bp vs the bid at the auction deadline
while the six month tailed by 25 bp. Both had very low bid covers. Volume has not been huge, but traders are fearful of being left short, so it doesn't take much to move the market. Spread products aren't sure yet what they think of Bernanke's move. Agency and mortgage spreads are unchanged. Corporate spreads are selectively wider with the new issue market pressuring financials. It has become a game of wait-and-see if the FED's two-step approach of extra liquidity and access to the discount window is enough to calm fear. The FED would really prefer NOT to have to cut the funds rate before the September 18 FOMC meeting.”

From JP Morgan: “Money markets remain under stress. In the United States, 3-month Treasury yields auctioned today at 91bp below their Friday yields, while the interbank lending rate is more or less unchanged, leading to a new high in the TED spread. In Europe, issuers of asset-backed commercial paper had trouble rolling over their debt. One encouraging development in financial markets is the continued decline in energy prices.”

Previous Today’s
Close Low Hi Close Change
3m T-Bill 3.754 2.505 3.837 3.072 -68bp
3y Treasury Yld 4.185 4.05 4.201 4.083 -10bp
5y Treasury Yld 4.358 4.274 4.376 4.292 -7bp
10y Treas Yld 4.685 4.61 4.702 4.626 -6bp
30y Treas Yld 4.986 4.947 5.02 4.969 -2bp
Dow 13079 12983 13181 13121 +42
Trans 4768 4769 4870 4855 +87
Util 487 481 490 488 +1
S&P 1446 1430.5 1451.75 1445.5 -.5
Dollar Index 81.43 81.26 81.49 81.38 -.035
Japan Yen 114.4 113.7 115.5 115 +.5
Oil 71.98 70.05 71.77 71.12 -.86