Today's Tidbits

Credit Crunch Likely to Lead to Recession
From FTN: “This is an old-fashioned credit crunch, something that has not happened in the US or Europe since the 1980s….This is not a small thing. A credit crunch – when the short-term credit markets seize up – is extraordinarily serious, almost always the precursor of a significant recession, and the fact that the ECB loaned $130bn last night suggests a severe absence of liquidity in the European banking system. Two of the biggest misunderstandings about this financial crisis are: 1. that it is a subprime mortgage crisis and 2. that it is hurting Wall Street and hedge funds, not Main Street. Subprime mortgages may have been the initial cause of the crisis, but it is becoming difficult to fund everything from jumbo mortgages to commercial loans. Spreads have widened across the board. Wall Street will be just fine once it adjusts to the new environment. End users of credit will be the ones to suffer, something that cannot happen without economic fallout. No economic expansion can long survive a significant decline in lending, even if it is a decline from “unrealistic” levels.”
From Bear Stearns: “Financial institutions are in capital accumulation and preservation mode. The incentive to lend is not evident…Spreads are widening, reflecting the increased cost of credit.”

Central Banks Worried About Liquidity
From Bloomberg: “The cost of borrowing dollars overnight jumped to the highest level in more than six years as the collapse of the U.S. subprime market made it harder for banks to secure funds…The overnight rate jumped to 5.86 percent today from 5.35 percent yesterday. “As liquidity is drying up, lines of credit are being pulled and commercial pater is more difficult to issue, so there appears to be a dash for cash… Unable to access the market or dispose of securities in an orderly fashion, banks and institutions are raising their desired holdings of cash. Greater demand, with supply unchanged, equals a higher price.””
From JP Morgan: “The drying up of short-term liquidity to financial institutions is a more serious concern to central banks than the shutdown in term credit financing
as credit reprices in a disorderly fashion. As a result, the ECB took action in order to protect the functioning of the Euro area money markets. It announced a special refi operation in which it agreed accept all bids at the current 4% policy target rate. This is first refi operation of this type conducted since the attacks of September 11. They allocated 94.8 billion euros today. In the first operation after September 11, they
allocated 69.3 billion euros. This action by the ECB sends two signals. First, that they are ready to provide liquidity to insure the smooth operation of European money markets.
Second, they are providing liquidity at their policy rate and thus far are not viewing a liquidity squeeze as a more fundamental reason to adjust its policy stance… the spreading of stress in the financial system highlights that we are far from a position of stability. That financial institutions are being constrained by a need to insure adequate liquidity and capital poses risks to the overall availability of credit in the coming months. The
spreading of credit problems to Europe will also weigh on global financial markets -- notably equities which have taken a step down this morning.”
From Market News International: “Fed Chairman Ben Bernanke appears to be bending over backward not to appear panicky in the face of mounting market fears that the subprime mess is spreading throughout the financial system and threatening an economically damaging "credit crunch." So far, as Fed watchers eagerly awaited a statement from the U.S. central bank, the Fed has chosen to let its body language -- its open market operations -- to convey its intention to ensure that there is adequate liquidity. But the New York Federal Reserve Bank's $24 billion reserve "add" -- $12 billion worth of overnight repurchase agreements plus $12 billion in 14-day repos -- proved unequal to the task of keeping the federal funds rate on target at 5.25%. Funds were trading at 5.5% or higher through much of Thursday morning… Lavorgna [chief U.S. economist for Deutsche Bank] noted that the spread between bank borrowings collateralized by Treasury securities and uncollateralized federal fund loans is a wider than usual 40 basis points. "That tells you there is a lot of fear in the market," he said.”
From Morgan Stanley: “The ECB only knew that there was a liquidity problem as the CP and the money market seized up, but they didn't know how big the problem was. By announcing that 100% of the bids would be allocated, they left it to the market to decide the size of the allocation. It so turned out that there was a huge need. Thus, the operation also helped the ECB to find out how big the problem was. The quick tender was part of the discovery procedure. The important message from the ECB is that they stand ready to do whatever is necessary. The EUR 94 bn question now is which (and how many) of the players are not only illiquid but insolvent.”

President Says No to Raising GSE Portfolio Caps Now
From Bloomberg: “President George W. Bush said Fannie Mae and Freddie Mac must first complete a ``robust reform package'' before…[“] I will consider other options,'' Bush told reporters at a White House news conference in response to a question about whether the two companies would be allowed to buy more mortgages to help spur the housing
market… Fannie Mae must limit its portfolio to $727.2 billion, its level on Dec. 31, 2005, while Freddie Mac must restrict annual growth of its $712.1 billion portfolio to 2 percent.
Fannie Mae and Freddie Mac own or guarantee 40 percent of the nation's $10.9 trillion residential mortgage market…”

30 Year Treasury Auction Suffers From Buyers Strike
From Lehman: “6 basis point tail in the long end, not surprisingly, putting massive pressure on the long end. 2s 30s now 16bp steeper on the day…”
From JP Morgan: “the issue only covered 1.57 times…the lowest for a bond auction since the 2/00 auction. Also, only 12.1% went to indirect bidders, which means the Street ended up w/ 7.895bb of the new issue.”
From Morgan Stanley: “…we are finally getting underlying signals that the re-pricing of risk is working its way down into the backend of the Treasury market – risk premiums and steeper curves are back. Put it this way, you know that the tide is changing when a Treasury auction is seen as a catalyst for risk assets to cheapen further…”

Fed Study of Carry Trade in Japan
From Dow Jones: “Japanese official institutions appear to have the largest positions in the yen carry trade, with more than 20 times more invested than the second-largest carry traders, Japanese banks, according to a report Wednesday from the U.S. Federal Reserve.
But the study was quick to note that there are are no published data on the magnitude of the yen carry trade through derivatives markets. That’s important, because it is in these markets that hedge funds, investment banks, charitable endowments and other investors that are thought to be lurking, with massive, and often times leveraged, carry trade positions. It’s possible that the positions held by these groups dwarf those of Japanese
official institutions. The 31-page report, titled “What Can The Data Tell Us About Carry Trades In Japanese Yen?,” was released in Washington by the Federal Reserve Board.
In defining the carry trade, the report said that “at its narrowest the carry trade refers to borrowing in low-interest currencies to fund deposits in high-interest currencies. At its
broadest the carry trade refers to any financial transaction that increases one’s high-yielding assets relative to one’s low-yielding assets.” This yen is the most common currency used in the borrowing phase of this strategy because Japan has had the lowest
interest rates in the world for more than 10 years, with its official rate currently at just 0.50%.”

MISC

From Deutsche Bank: “The Overnight LIBOR-fed funds target has risen to the highest level since the aftermath of the 9/11 terrorist attacks, and is now at 61 bp, while the average has been around 5 bp.”

From RBSGC: “The Fed Fund Futures market now prices in near certainty of an ease at the next FOMC meeting - Sept 18.”

From Market News International: “The investment by the Chinese government's new sovereign wealth fund in The Blackstone Group ahead of the private equity firm's initial public offering has fallen short of expectations, a government official familiar with the situation told Market News International, prompting a rethink of its investment strategy.”

From Goldman Sachs: “The central banks and the governments in the Eurozone are prohibited by EU rules from bailing out banks (or anyone else) in trouble. Hence, the solution to isolated cases is to get a "friendly" public or private institution to step in. But what's the capacity of the system to do this? Nobody knows (not even the central banks, I am sure), but if there are more institutions in trouble and/or there is a really big one (relative to the balance sheets of those "friendly institutions"), then you have greater problem to which there is only one solution: Fire fighting. Get the ECB to provide liquidity, and that’s what happened this morning….we are left with the following questions: Who are the CEO(s) who made that (or those) calls to the central banks that they could not survive until the next tender on Tuesday?”

From Bloomberg: “The U.S. economy will grow less than previously forecast as a rout in subprime borrowing hampers consumer spending, according to a survey of economists … Rising delinquencies in the subprime mortgage market are prompting lenders to limit the availability of credit, which may mean Americans buy fewer cars and spend less on vacations. The slackening expansion won't force the Federal Reserve to lower interest rates for the rest of the year as officials stay focused on taming inflation, economists said.”

From Deutsche Bank: “…the worst is by no means past us. One transmission mechanism that we would monitor closely is the subprime effect on European and Asian banks. Some of the mark-to-market losses can be hidden for extended periods, but when actual default experience starts to pick up and investors feel actual cash flow losses, high event risk should become more evident.”

From Dow Jones: “The back-to-school shopping season had a shaky start in July, stoking worries that consumers are feeling the pinch of a stumbling housing market and stiff prices for gasoline and food. Wal-Mart Stores Inc.’s July sales were slightly better than Wall Street had expected, but the big discounter cited strong demand among budget-minded shoppers for its low-priced groceries, as well as aggressive price cuts it began at the start of the month. At the malls, chains like Macy’s Inc., Gap Inc. and AnnTaylor Stores Corp. reported declines in comparable sales as they struggled to lure customers with heavy promotions.”

From Merrill Lynch: “Unlike Fed officials, we think that "diversification" introduces its own form of contagion, versus the LTCM form of contagion, as counter-party risk surges in the current context, secondary markets become highly illiquid, security prices are neither market determined, nor known, and a seizure of risk taking can nonetheless emerge - where market participants "disengage from risk taking" - just as they did in
August-October 1998 …”

From Merrill Lynch: “At an FOMC meeting several years ago, then Governor Janet Yellen asked Alan Greenspan what his definition of price stability was, and he didn't respond with 1-2% on "core". He said zero on the headline. But he added that the government statistics were so imperfect that one could not really target a CPI or PCE price index. This is key.”

From RBSGC: “…during the August- October 1998 credit crunch and also in June-July 2003 convexity event, GSEs grew their retained portfolio by almost 10%-15% providing much needed liquidity in the market.”

From Merrill Lynch: “This is a James Cramer market - it's manic.”

End-of-Day Market Update

From Bloomberg: “Treasuries rose, pushing the two-year note's yield down the most since 2004… Yields on short-term loans to packagers of consumer and business debt rose
to a six-year high today as subprime mortgage losses chastened money-market investors… Ten-year yields exceeded two-year yields by 27 basis points, the widest difference, or spread, since September 2005…” [2y Treasury yields down 22 to 4.44%, 10y Treasury yields drop 7 to 4.77%. 2/10 Treasury curve has bull steepened by 14bp]

From UBS: “Swaps saw heavy volume in curve trades all day long, and 10-year spreads ranged from 68.5bps to 72bps, finishing the day at 69.5bps. Front end swap spreads widened significantly more. Agencies saw mixed flows and traded mixed to swaps. Mortgages were under pressure all day with volatility up, and were 10 ticks wider to Treasuries and 8 ticks wider to swaps.”

From RBSGC: “Equities plunged lower -- with the major U.S. indices down -2% on the day -- solid downtrade, but still shy of the recent lows.” [Dow down 387, S&P down 44]
From CNN: “The Dow suffered its second worst session of the year Thursday as worries about the global credit market sparked a broad selloff in stocks, following a three-session rally. Bond prices rose as jittery investors dumped stocks in favor of the so-called safer haven of Treasuries… The Dow's decline Thursday equaled a loss of 2.8 percent…The broader S&P 500 index dropped 2.9 percent.”

The dollar index rose .46 to 80.79, and gold fell $13.

Oil fell to a new one month low, closing down 56 cents to $71.59 for WTI futures.