Today's Tidbits

Tighter Credit Could Slow U.S. GDP Growth
From Reuters: “…tighter lending standards are starting to pinch consumer and business spending, threatening to slow already tepid U.S. economic growth… banks are increasingly leery of backing all sorts of risky loans, not just subprime mortgages for borrowers with shaky credit. "All the hoopla about subprime has created a sense among creditors and lenders that maybe they should rethink their easy terms,"… "It means that we have what is equivalent to a Fed (interest rate) tightening going on." Reduced spending stemming from the tighter credit terms could shave …off the U.S. economic growth rate… more sensible lending standards would be good for the economy in the long run… Business investment was a key factor behind the stronger-than-expected second-quarter gross domestic product figure issued last week. While consumer spending advanced at a slim 1.3 percent annual rate in the second quarter, business investment rose at an 8.1 percent pace. If companies pull back just as consumer spending is tapering off, it would hamstring the U.S. economy. Tighter credit is already stinging some smaller retail trade companies that supply goods to stores… If terms stay tight through the critical holiday shopping season and into next year, suppliers will have little choice but to cut back on shipments… Another subtle side effect of tightening credit is the decline in corporate share repurchases. As borrowing costs rise, companies have less incentive to ramp up debt to fund major stock buybacks, which typically push up share prices.”

Central Banks Appreciate Seeing Market Risks Re-Evaluated Higher
From Lehman: “ECB President Jean-Claude Trichet announced “strong vigilance”, and therefore signalled that a rate hike in September is very likely…The ECB president also addressed financial market developments. He recalled that “there had been some underpricing of risks” in the past, and that we are “now seeing the process of a progressive risk reappreciation”. He also mentioned a “period of nervosity (nervousness)” in the markets which deserves “particular attention”. To us, this means that the ECB is welcoming some of the repricing, but also that it is ready to act should financial market conditions deteriorate significantly.”

U.S. Less Dependent on Bank Lending Than Other Countries
From Wachovia: “Private debt securities comprise about 40% of total financing in the U.S. economy, and adding in the stock market brings total U.S. financing via the capital markets to 80%. No other major economy comes close to that percentage…the financial systems of the Euro-zone and the United Kingdom are much more dependent on bank lending than the United States. The same statement applies to most developing countries. The Canadian and Japanese economies are roughly as dependent on capital markets financing as they are on bank financing…in the third quarter of 1998, when U.S. capital markets essentially ground to a halt, new issuance in the corporate bond market plummeted 67%. Total U.S. bank lending was down only 5% during that quarter. Therefore, in the current environment, economies that are more dependent on financing via capital markets may be more adversely affected by widespread credit restriction than economies that are financed primarily via bank lending. In other words, the United States appears to be the economy that would be most negatively impacted by the direct financial effects of a credit crunch centered in the bond markets.”

Month-End Valuations Getting a Lot of Scrutiny and Disagreements
From The Financial Times: “Bitter disputes are developing behind the scenes in the hedge fund industry about the way funds are valuing some assets for their end-of-month performance reports…“There is a lot of wrangling going on behind the scenes, because it’s getting hard to agree [about] how to value a lot of stuff,” says one US banking official. “The bid-offer spreads can be incredibly wide – and that can really affect the NAV.”
The issue of valuation is particularly critical at present because many hedge funds typically give their investors a NAV report at the end of every month. The data on funds’ NAV for the end of July is currently awaited with particular eagerness by many credit funds, since some are believed to have suffered painful losses as a result of the recent market turmoil – not only in the subprime sector but corporate credit markets in general.
Indeed, many bankers assume there will be further hedge fund implosions during coming weeks, adding to the list of those already forced to close their doors, or to take extreme measures such as banning investor redemptions…However, although these pressures make July’s NAV data particularly important, it is often difficult to ascribe precise values to many complex financial instruments even in calm markets, because these markets are illiquid. As a result, funds have often relied on models to value these instruments. However, there is growing unease these days about the quality of some of these models, given that conditions in the subprime sector, for example, are turning out to be much worse than models have assumed. Worse still, the sharp swings in credit prices now also make it hard to value instruments according to market or broker quotes. “Illiquidity is making those month-end [valuation] marks look atrocious,” …in the mainstream credit default swaps sector the bid-offer spread can now now be “as high as 20 basis points” (or between 5 and 20 per cent of the actual spread). Some hedge fund managers yesterday suggested that the largest, best-capitalised funds will now seek to take a very conservative approach to valuations in an effort to build credibility with investors.
However, with banks now raising margin calls, some weaker funds are scrambling for survival – raising the pressure for accounting tricks…“You are getting a distressed subprime asset which one person values at 20 cents in the dollar, and someone else values at 40 cents. “There is a lot of scope for argument,” said one banker.”

Evaporating Liquidity Hurts Investors
From The Financial Times: “When an ordinary sounding Australian mutual fund run by Macquarie Bank’s asset management division warned investors they could lose up to 25 per cent of their money this week it was shocking for two reasons. First, it was a retail fund, so the investors were everyday people. Second, their money had not been anywhere near US subprime mortgages, which have been at the centre of recent market turmoil.
The fund was actually invested in senior secured corporate loans, which are mainly the leveraged debt used in private equity-backed buy-outs – and these assets were fundamentally sound and performing well, the fund insisted. What caused the embarrassing loss was “supply-demand imbalances” in the market – which in plain English means many need to sell but few want to buy. The saga illustrates an ominous point, namely that as market turmoil rises, financial problems are no longer simply confined to a risky corner of the US mortgage market. This stems from another key theme now haunting the markets: namely that liquidity is evaporating from numerous corners of the financial world, as both investors in hedge funds and the banks that lend to them try to cut and run from recent losses.””
From The Los Angeles Times: “Some hedge funds that have suffered losses on investments are closing the gate on clients who want to pull money out, a move that could further undermine confidence in already shaky financial markets. Temporarily barring withdrawals, though legal, also could damage the image of the hedge fund industry, which in recent years has attracted hordes of well-heeled investors seeking high returns. The industry has mushroomed to 9,700 funds with $1.7 trillion in assets…Fund managers say that withdrawal limits protect their investors by preventing sales of securities at deeply depressed prices. But some analysts say news of unexpected hedge fund suspensions could prompt nervous investors in other funds to demand their money back, fearing that the exit door could slam shut on them in the next few months should stock and bond market losses deepen. Such a run-on-the-bank scenario also could hurt investors who have no money in hedge funds because forced asset sales could drive markets overall lower.”

Rating Agencies and Investors Seldom Saw Investment Bank Due-Diligence Reports
From Reuters: “Investment banks that bundle and sell home mortgages often commissioned reports showing growing risks in subprime loans to less creditworthy borrowers but did not pass on much of the information to credit rating agencies or investors, according to some of those who prepared the reports. The mortgage consultants, known as due-diligence firms, were hired by investment banks to make sure blocks of mortgages conformed to the mortgage seller's own standards. The studies provided a first glimpse of loan quality for ratings agencies and investors who do not normally see the full reports… But due-diligence firms … are not empowered to release the reports… While subprime mortgage security prospectuses warned about the perils of such loans in recent years, they did not enumerate the findings of due-diligence reports… Moody's customarily receives summaries of due-diligence studies but not the full reports, which might have helped the ratings agency evaluate now-troubled mortgage securities, said Nicolas Weill, chief credit officer for Moody's asset finance team. "It's difficult to know what would have happened if we had gotten that information," he said… However, while due diligence reports may contain facts that ratings agencies seek, they might not be interested in seeing the reports…"The International Organization of Securities Commissions code of conduct requires that they use all available information in their ratings process," … "To require them to look at due diligence would move them to another level of responsibility."”

MISC
From Dow Jones: “Factory orders climbed during June on the strength of higher demand for airplanes, but the increase was smaller than expected as bookings weakened for cars, computers and electrical equipment…a yardstick for business investment demand - non-defense capital goods orders excluding aircraft - was flat in June, after dropping 1.5% in May.”From JP Morgan: “Livestock (+8.6%) was the best-performing [commodity] sector in July, followed by energy (+6.5%).”

From Goldman Sachs: “…we highlighted the disparity between strong US surveys of industrial activity and what appeared to be a significant slowdown in household demand. Discrepancies of this sort must be reconciled through a rebound in demand, cutbacks in production, or both. Early signs suggest that a good part of this adjustment is coming on the production side.”

From JP Morgan: “Movements in yield curves are closely linked to monetary policy cycles… yield curves tend to flatten when central banks tighten monetary policy and steepen when they ease.”

From Merrill Lynch: “…the trough in the CBOE Volatility Index (VIX) coincided almost perfectly with the BOJ's initial rate hike of this cycle back in February. The much-discussed yen carry trade (i.e., borrowing at low interest rates in Yen to invest in higher returning assets elsewhere in the world) becomes incrementally expensive if the yen appreciates and/or Japanese interest rates rise. Thus, this year's increase in financial market volatility might be reflecting the early stages of the unwinding of such carry trades. Along that line of reasoning, we have further argued that anything that might cause the yen to appreciate could foster still higher financial market volatility.”
From The U.S. Treasury: “The overall compliance rate achieved under the U.S. revenue system is quite high. For the 2001 tax year, the IRS estimates that over 86 percent of tax liabilities were collected, after factoring in late payments and recoveries from IRS enforcement activities. Nevertheless, an unacceptable amount of the tax that should be paid every year is not, short-changing the vast majority of Americans who pay their taxes accurately and giving rise to the tax gap. The gross tax gap was estimated to be $345 billion in 2001. After enforcement effects and late payments, this number was reduced to a net tax gap of approximately $290 billion.”
From Merrill Lynch: “We believe it will be difficult for the market to do well as Financials underperform amidst rising bond yields and sub prime worries. After all, they comprise around 20% of total market value. However, we do not believe that this sector needs to outperform in order for the market to rally. Keep in mind that Financials have been at best a market performer for almost all of the past five years, despite respectable market returns.”

From UBS: “The net slowing in employment growth this year has been despite no significant change in jobless claims. Implicitly, the slowing has come from reduced hiring rather than increased layoffs.”
End-of-Day Market Update
Two and ten year Treasury yields declined 2.5bp in quiet trade verses 5pm yesterday.
Equities rose for the third day this week. The Dow is closing up 101 to 13,463. S&P +6.
The dollar index slipped .19 to 80.68. Gold eased a dollar to $665.90.
Oil futures rallied 40 cents to $76.93, down from an intraday high yesterday of $78.77.