Today's Tidbits

Market Expectations of FOMC
From The Wall Street Journal: “Investors are putting a lot of hope in the Federal Reserve’s ability to ride to the rescue tomorrow. Maybe too much hope…a rate cut would offer little immediate help for the fundamental problems weighing on the nation’s economy and financial markets. These include a worsening housing slump and high gasoline prices, which are damping consumer spending, and fears of further defaults on the billions of dollars of low-quality loans that have been used to finance mortgages and corporate takeovers. Even if the Fed carries out a series of rate cuts, the economy and stock market are likely to be dealing with the fallout from these problems well into next year.”
From Merrill Lynch: “We're likely going to see the first cut in the Funds rate since June/03. Whether the Fed goes 25 bps or 50 bps could be a close call - two-thirds of economists expect a 25 bps point cut while the Fed funds futures market is almost priced for a 50 bps move - the press release will be key for future rate relief.”
From Lehman: “Don’t look for the mortgage ARM reset Fed bailout just yet. That may be the story for late 2008.”
From Market News International: “While official comments have not been uniform, their main thrust has been in line with market expectations that the FOMC will cut the federal funds rate 25 basis points to 5.00%. Bernanke and his fellow policymakers have had plenty of chances to change those expectations, but have not taken them. So it would be astonishing if the FOMC were to stay on hold and disappoint the market. Not that the Fed always strives to give the market just what it wants. It has proven that in spades over the past year. But generally speaking the Fed does not go out of its way to surprise the markets -- particularly at a time of unsettled financial conditions. If there is to be a surprise it would be in the direction of a larger than expected rate cut.”

Bear Stearns Turns Bearish
From Bear Stearns: “We expect a material U.S. slowdown beginning in the fourth quarter and broadening to a global slowdown in 2008. We think the August-September credit market turbulence caused a downward inflection point in the global outlook. It took the liquidity-filled punch bowl away…In coming months, we think this will cause an extra drag on jobs, earnings, consumption and investment (including residential, commercial and business spending)… We don’t expect a U.S. or global recession…A key variable in our soft-landing view is whether the dollar price of assets is way too high – for land, houses, skyscrapers, commodities, equities. We think prices will be tested strenuously in coming months due the abruptness of the downward inflection point in credit, but will find buyers. The dollar has lost substantial value since 2002, so much of the asset price run-up is more of an adjustment to the weaker value of the dollar, rather than a “bubble” in real values. We expect some further weakness in U.S. house prices, but we think the housing excesses showed up more in housing starts than in nationwide median prices. If it turns out this way -- that the excesses were more in activity than in prices – then we should see an economic slowdown but not a recession or a bear market in asset prices.” [This is notable because Bear Stearns has consistently been among the most bullish on the economy.]
Greenspan’s Comments on Housing Market
From The Wall Street Journal: “There is now a ‘very large’ inventory of unsold, newly built homes whose condition is deteriorating more rapicly, than, say, a steel mill’s, and that puts pressure on builders to sell them quickly, he said. As a result, ‘we have the capability of far bigger price declines,’ which will pinch home equity, lead to more defaults on subprime mortgages and pressure consumer spending. The probability of a recession, which earlier this year he put at one-third, is now ‘slightly more than a third,” he replied.”
From The Financial Times: “US house prices are likely to fall significantly from their present levels, Alan Greenspan has told the Financial Times, admitting that there was a bubble in the US housing market…the former chairman of the Federal Reserve said the decline in house prices "is going to be larger than most people expect"…Mr Greenspan said he would expect "as a minimum, large single-digit" percentage declines in US house prices from peak to trough and added that he would not be surprised if the fall was "in double digits". Mr Greenspan said house prices were probably already down about 2-3 per cent from their peak on a national level. However, he cautioned that it was very difficult to predict how big the decline would be…Mr Greenspan told the FT that froth "was a euphemism for a bubble"”
From Fortune: “…there is no question that there is an overhang of inventories, especially newly constructed, unoccupied single-family homes. I judge there are about 200,000 units that are excess. And at the rate we're going now, we're running off a very small number of these inventories a month. These units are going to overhang the structure and move prices inexorably lower. So I think we're going through a period that is not over yet, and it's important that we bring this to an end sooner rather than later, because it has a corrosive effect on the economy.”

Greenspan on Current Market Risks and Recent Financial Product Innovations
From The Financial Times: But Mr Greenspan said that his successors at the Fed - who meet tomorrow to set interest rates - would have to be careful not to ease rates too aggressively, because the risk of an"inflationary resurgence" was greater now than when he was Fed chief… The former chairman said the current turmoil in financial markets was "an accident waiting to happen". He said the price of risk had fallen to unsustainably low levels beforehand, with investors addicted to asset-backed securities that offered some additional yield over Treasury bonds as if they were "cocaine". Mr Greenspan said this demand induced the big increase in the origination of subprime mortgages by mortgage brokers. The rise in defaults on subprime mortgages was only the trigger that set off a broad re-evaluation of risk, he argued. Mr Greenspan said the off-balance sheet investment vehicles that issued much of the asset-backed commercial paper represented a "savings and loans disaster waiting to happen" because of the mismatch between their assets and liabilities. Mr Greenspan thought the issuance of asset-backed commercial paper "is probably not going to get back to where it was". They had "five-year maturity assets financed with 30-day commercial paper", he said. The former Fed chairman said collateralised debt obligations - securities that slice up and repackage loans to meet the risk-appetite of different investors - "will never get back to the levels and structures that they were, because now everybody knows you cannot price them". He added that in an innovative financial market "there will always be products that fail". But he said he believed that credit default swaps were "here to stay" and had demonstrated their capacity to diversify risk.”
From Deutsche Bank: “Probably the most interesting aspect of the accounts of Greenspan's book has been his expectation that the low-inflation period (due to globalization and productivity) is over, and that nominal bond yields would have to rise to 8% and short-term interest rates to "double digits" in order to keep inflation at around 1-2%. This is probably a good time for TIPS traders.”
From Fortune: “How would you judge chairman Ben Bernanke's response so far?
I think it's been a very sensible one, because the board is confronted with something I was not confronted with, namely, evidence of finally coming out of this disinflationary trend. Cost pressures are beginning to build around the world. This suggests that, longer term, the Fed's going to have to be tighter. It means that stock prices are going to have some difficulty moving forward. Shorter term, clearly, it's got problems with very significant credit disruptions and turmoil. [In my tenure] we had a relatively easy task in lowering rates without concern about triggering inflation. I regret that that is no longer the case… We have a dysfunctional political system in the sense that there are very serious fiscal problems out there, most importantly Medicare. As best I can judge, when the baby boom retires, we are going to have to either raise taxes very sharply or cut benefits by half. No politician wants to confront this. And this is a very sad event because what's at stake here is the fiscal stability of the American government.”

Stock Market Has Been Poor Predictor of Recessions During Last 50 Years
From Citi: “There have been seven recessions in the U.S. over the past 50 years. So, I went back to see if stocks are truly a good leader in forecasting recessions. On average, the Dow has fallen 15.3% into recessions as measured from the nearest market high to the first GDP print after NBER says a recession start (remember that NBER only picks the start of a recession well after it has already begun). The range was -7.8% to -24.5%. Obviously, not all 15% declines led to recession most notably '87, '89 and '98. Financial crises have not been a good leading indicator with only 1 of 5 leading to recession with three others occurring during the downturn. Oil supply shocks have a better record (3 for 3 - one of which coincided with the lone financial crisis that preceded a recession - the 1990 S&L crisis). Even non-correlated events have a better record than financial woes. 3 of 4 of the Mets World Series appearances have seen economic dips within weeks of the final out! Ahmadinejad and Pedro Martinez could have more to say about recession than where 3-month Libor is, statistically speaking.”

Second Quarter Flow-of-Funds Data from Fed on Debt Growth and Net Worth
From JP Morgan: “According to the 2Q Flow of Funds report, total debt of the nonfinancial sector increased at a 7.1% annual rate last quarter, down 0.8% points from the previous quarter. Federal debt contracted at a 1.4% rate, the first decline in that series since the first half of 2001; home mortgage debt growth continued to ease, slipping to 7.3% from 7.7%, but business borrowing perked up to a 10.6% rate from 8.9% the prior quarter. The financing gap -- capital expenditures less internal funds -- is now a fairly large $237 billion, last quarter's gap was revised up massively, from $18 billion to $203 billion, a revision reflecting a variety of factors. This highlights a vulnerability of the corporate sector that the previous data did not reveal: because firms have to access credit markets to fund their capital spending, rather than finance them out of internal funds as the unrevised data suggested was feasible, the capital spending outlook now looks more sensitive to stresses in the credit markets. A more favorable picture emerged from the household balance sheet: household net worth increased to $57.8 trillion, which represents 571% of disposable income, the highest the net worth-to-income ratio has stood since 2000. The $1.2 trillion increase in household net worth in the second quarter was mostly the result of holding gains on financial assets. The Flow of Funds measure of the US funding needs vis-a-vis the rest of the world suggests a smaller gap than the current account data. Although the size of the discrepancy is not unprecedented, it confirms a message from the NIPA's measure of external funding needs (i.e. national saving less national investment). Whereas the current account deficit number is $738 billion, the NIPA and Flow of Funds external funding numbers are, respectively, $654 and $601 billion. In a stark turn-about, in 2Q ABS issuers funding needs were met with a surge in CP issuance, $295 billion (annual rate), up from $46 billion the previous quarter, at the same time their funding out of bonds fell to $229 billion from $527 billion the previous quarter. The net change in mortgages increased for the first time in over a year, though all the increase was due to commercial mortgages which increased at a record $343 billion pace last quarter. Funding for all mortgages by ABS issuers declined to $401 billion rate even as agency mortgage pools increased at a record $544 billion annual pace.”
From Dow Jones: “Household net worth is a measure of total assets, such as houses and pensions, minus total liabilities, such as mortgages and credit card debt. U.S. household debt rose at a 7.1% annual rate in the second quarter, matching the first quarter.”

MISC

From Morgan Stanley: “Our repo desk expects quarter end to be an issue . Already Trsy collateral at quarter end is trading at 4%. Customers want to be long quality for reporting purposes at quarter end.”

From RBSGC: “MBS holdings by US banks increased by $7 bn with pass-through holdings up $2 bn and CMO holdings up $5 bn. MBS holding were down $11 bn since the start of this year. Deposits increased by $6 bn over the past week. Since the start of this year, deposits increased $213 bn. Commercial and industrial loans increased by $14 bn for all banks over the week. Since the start of the year, C&I loans increased by $137 bn. Whole loan holdings increased by $9 bn over the week. Since the beginning of the year, whole loan holdings increased by $81 bn. Due to data lags from the Fed, they recently reported increases in both deposits (+$6 bn) and asset holdings (+$44 bn) for the week ended on September 5. All numbers are seasonally adjusted.”

From Merrill Lynch: “The [U of Michigan consumer confidence] index assessing whether now is a good time to buy a home because interest rates are low actually sank to 14 in September from 19 in August - and that is the lowest number since late '90. At the same time, the index gauging whether it is a bad time to buy a home because interest rates are too high and credit too tight jumped to 23 from 20 - the highest since the summer of '89 when that credit crunch was in its infancy stage.”

From Reuters: “Pacific Investment Management Co is planning to launch a $2 billion distressed-debt fund…The Pimco Distressed Mortgage Fund will invest in a variety of assets, including mortgage-backed securities, asset-backed securities and collateralized debt obligations…”

From Morgan Stanley: “US Money markets ended last week in much better shape than they have been in all month. CP spreads over the Fed Funds target have fallen by more than 25bp from their August highs. The spread between 1m LIBOR and Funds has also fallen by 20bp from its August highs. Note also that quality spreads within the CP markets have also narrowed. Certainly, these spreads levels remain very elevated, demonstrating money-market stresses remain high – but it is easy to argue that things are getting better (and it would be very difficulty to argue that they are getting worse).”

From Dow Jones: “U.S. Treasury Secretary Henry Paulson said regulators shouldn’t rush to impose new rules on financial markets in reaction to the recent crisis in credit markets…Financial market turbulence “will take some time” to work through, and regulators must ensure that any new requirements for financial services firms don’t stunt innovation, Paulson said. “There is great vigilance now on the part of regulators, in terms of staying close to markets, as we work our way through this situation, Paulson said. “We want to get the balance right...we don’t want to rush to judgment and overreact.”

From Dow Jones: “U.S. corporate executives think the effect of recent credit market problems on their businesses will be limited, according to a survey by the Business Roundtable. Sixty percent of chief executives surveyed said they did not expect “substantial” effects from credit market turmoil on business prospects. Forty percent said they did foresee substantial effects, according to the Business Roundtable, an association of chief executives at major companies with combined annual revenues of $4.5 trillion and more than 10 million employees. The organization’s third quarter outlook index - which combines expectations for sales, investment and payrolls - fell 4.5 points from the previous quarter to 77.4. Still, that’s well above the breakeven level of 50 between expansion and contraction.”

End-of-Day Market Update

From RBSGC: “The bond market drifted a bit lower, the curve a bit steeper, and was joined by stocks, which also edged a bit lower on an otherwise lackluster day.”

From Dow Jones: “Crude oil futures rose to an intraday record on speculation the Federal will cut interest rates. The expiration of crude oil options, as well as talk of more Atlantic hurricanes, also spurred prices higher. The front-month October light, sweet crude contract on the New York Mercantile Exchange rose as much as $1.40, or
1.8%, to an intraday record of $80.50 a barrel beating the previous record of $80.36 set Friday.”

Dow down 39 to 13,403. Dollar index up .1 to 79.72. Gold up $10 to $718, highest close in over a year.