Today's Tidbits

August State Employment Date Differs From National Data –Seasonal Adjustments for Teachers is a Suspect
From The Wall Street Journal: “Many economists suspect the drop in August payrolls was exaggerated by a fluky fall in local government payrolls, and new data from the Bureau of Labor Statistics supports that. On Tuesday the BLS released state payroll data for August. If you sum up the changes across the 50 states and the District of Columbia, the total rose 159,000, compared to the decline of 4,000 in the national data…the difference is unusually large. In part that may simply be catchup, since the sum of the states total has lagged the national total for some time. But he says the principal source of divergence in August appears to be in government payrolls. The national tally of government jobs fell 28,000, while the sum-of-the-states tally rose 88,000…evidence that the national data have been distorted by quirky seasonal adjustment, which is made difficult by the timing issues surrounding academic years, and the inconsistency in how teachers are paid over the summer. Some get paid on a 12-month basis, others on a 9- or 10-month basis. Any shift from year to year in the relative incidence of months-paid will play havoc with the seasonally adjusted teacher payrolls. Still, even excluding government, the sum-of-the-states data shows a gain of 70,000 in private payrolls vs. 24,000 in the national payroll survey and 38,000 in the ADP/Macroeconomic Advisers report, notes Andrew Tilton of Goldman Sachs. Mr. Tilton notes that at the state level, the disparity between the payroll and household surveys persists. After dividing the country into 20 regions of about 5 million or more workers each, he finds payroll employment fell in only three, but household employment fell in 15. He attributes this both to higher job loss in the informal sector home contractors, real estate agents, day laborers, and so on who do not show up on anyone's payroll and among young people who are not even looking for work, a very typical feature of softening labor markets.”

Questioning the Validity of Birth/Death Adjustment in Employment Data
From Northern Trust: “Employment measures tend to be coincident rather than leading indicators of cyclical economic behavior. One relatively reliable employment measure is the employment-to-population ratio. This measures the number of people employed relative to the number of people who potentially could be in the labor force. Typically, when the trend in the employment-to-population ratio turns down, the economy already has entered a recession or is about to. It appears as though the employment-to-population ratio has recently entered a downtrend. While on the subject of employment indicators, we would like to discuss one that seems unreliable to us – nonfarm payrolls. The principal reason we find it unreliable is the so-called birth/death adjustment the bean counters at the Bureau of Labor Statistics (BLS) make each month. The birth/death adjustment is an attempt to account for the net new jobs created by businesses not yet reporting to the BLS… in the 12 months ended August 2007, there had been a net increase in nonfarm payrolls, including the birth/death adjustment, of 1.521 million. But when the birth/death adjustment was excluded, the net increase in nonfarm payrolls was only 407,000. Another way to look at this is to calculate the birth/death adjustment’s percentage contribution to the 12-month change in total nonfarm payrolls. … in the 12 months ended August 2007 the birth/death adjustment represent 73% of the increase in nonfarm payrolls compared to only 31% in March 2006. Enquiring minds want to know why the birth/death adjustment’s contribution has more than doubled since March 2006. With small businesses expressing reservations about expanding their operations, is it reasonable to expect that there has been a sharp increase in business start-ups whose hiring is not being captured in the BLS’s sample of establishments?”

Comparing Housing Data
From The Boston Globe: “The explosion in home foreclosures and a tightening in mortgage lending dragged down real estate prices in Massachusetts in August, a real estate research and publishing firm reported yesterday. Warren Group in Boston said median single-family home prices last month fell 4.9 percent, to $314,000, from August 2006 - the 16th consecutive month in which prices have declined. The number of sales in the period fell by 1.5 percent. But the Massachusetts Association of Realtors reported a starkly different view of the housing market, based on a smaller number of transactions than those recorded by Warren Group. The realtors group said home prices in creased 1.4 percent, to a median of $357,000, from August 2006, while the number of sales rose a robust 6.6 percent. The realtor group's report is based mostly on sales brokered by real estate agents, while the larger pool of housing transactions tracked by Warren Group includes sales made directly by homeowners and lenders' repossessions from borrowers and sales of foreclosed homes.”

Longer Lives May Push Retirees Back to Equities and Risk Taking
From Morgan Stanley: “On the one hand, it is thought that global ageing may raise the equity premium, as ageing households become less willing to warehouse risk. As a result, ageing could benefit bond markets relative to equity markets. (In most countries, bills and bonds still rank first in asset allocation, ranging from 50-95%.) This is, in fact, what most academicians contend should be the case. However, recent experience in Japan suggests an interesting alternative hypothesis. Fixed retirement age, coupled with ever improving life expectancy, has created a ‘longevity risk’, whereby retirees can no longer be confident of their ability to defend their lifestyle if they end up living much longer than they expect at the time of their retirement. In the case of Japan, this has led to more risk-taking, not less, as retirees try to enhance their expected investment returns by diversifying away from assets with low credit risk. In contrast to the first hypothesis, this alternative hypothesis suggests that retirees should have a bigger appetite for equities.
Data suggest that, while bills and bonds still account for the bulk of total pension holdings in the world, the share that is allocated to equities is rising. Between 1994 and 2005, there was indeed such an increase in exposure to equities. Incidentally, the recent decision by Norway’s Government Pension Fund, Global, to alter its bond-to-equity allocation from 60:40 to 40:60 is totally consistent with this global trend. What this means is that, on the margin, as the developed world ages, there could be a structural bias in favour of equities over bonds.”

LIBOR’s Validity Under Scrutiny
From The Financial Times: “As the credit squeeze has spread in recent months, the Libor benchmark has, at least until recently, risen relentlessly. Consequently, many observers have seized on these rates as a handy, visible litmus test of banking stress, not least because the rest of the interbank market tends to be very opaque and thus not easily monitored…[But] the recent turmoil is prompting suggestions that Libor is no longer offering such an accurate benchmark of borrowing costs as before…“The Libor rates are a bit of a fiction. The number on the screen doesn’t always match what we see now,” complains the treasurer of one of the largest City banks…One of these is a growing divergence in the rates that different banks have been quoting to borrow and lend money between themselves. For although the banks used to move in a pack, quoting rates that were almost identical, this pattern broke down a couple of months ago – and by the middle of this month the gap between these quotes had sometimes risen to almost 10 basis points for three … the second, more pernicious trend is that as banks have hoarded liquidity this summer, some have been refusing to conduct trades at all at the official, “posted” rates, even when these rates have been displayed on Reuters…Some observers think this is just a short-term reaction to the current crisis. However, it may also reflect a longer-term shift. This is because one key, albeit largely unnoticed, feature of the banking world in recent years is that many large banks have reduced their reliance on the interbank market by tapping cash-rich companies and pensions funds for finance instead. The recent crisis appears to have accelerated this trend. In particular, it appears that some large banks have in effect been abandoning the interbank sector in recent weeks, turning to corporate or pension clients for funding by using innovative repurchase agreements. This trend is bad news for smaller institutions, such as British mortgage lenders, because these, unlike large banks, generally do not have any alternative ways of raising funds outside the interbank world. Thus it is that these institutions appear to have suffered worse from the latest squeeze. Few observers expect this pattern to reverse soon…The BBA Libor benchmark first emerged in the 1980s, because of industry demand for an accurate measure of the rate at which banks would lend money to each other. As London’s status as an international financial centre subsequently grew, the role of BBA Libor also rose, and it is now used to calculate the interest rates for a range of financial instruments and derivatives around the world…The BBA calculates the rates together with Reuters each day, usually before noon UK time. It assembles the interbank borrowing rates from 16 contributor panel banks at 11am, looks at the middle 50 per cent of these rates and uses these to calculate an average. These are then posted on Reuters as the BBA Libor rate.”

Importance of Modeling Extreme Tail Risk
From Business Week: “The big credit-rating agencies, Standard & Poor's and Moody's Investors Service, aren't known for making rash moves when changing their grades on bonds and other securities. The odds are only about 1 in 10,000 that a bond will go from the highest grade, AAA, to the low-quality CCC level during a calendar year. So imagine investors' surprise on Aug. 21 when, in a single day, S&P slashed its ratings on two sets of AAA bonds backed by residential mortgage securities to CCC+ and CCC, instantly changing their status from top quality to pure junk… the very structure of the vehicles that issued the bonds heightened the risk of dramatic downgrades--and that the ratings agencies were aware of this risk, however remote, from the start. The agencies have long contended that they shouldn't be blamed for the subprime meltdown, even though they gave high grades to most of the mortgage-backed bonds whose values have since plunged. Investors consider two main variables when assessing a bond: its price and the interest payments it generates. The agencies say their ratings reflect only the latter. Ratings are judgments about whether a bond will pay interest on schedule until it matures--not indicators of how market forces might affect its price. "Unlike market prices, [bond ratings] do not fluctuate on the basis of market sentiment," wrote S&P Executive Vice-President Vickie A. Tillman in an Aug. 31 Wall Street Journal commentary. But the downgrades made 10 days earlier were indeed driven by market forces. Because of the particular way the vehicles were structured, the credit market plunge that began in June hindered their ability to pay interest on time… The ratings agencies stress that the CDOs were victims of a market storm that resulted in prices for mortgage-backed securities falling by a magnitude 10 to 15 times greater than any time on record. "We've never seen anything like it in structured finance," says Paul Kerlogue, senior credit officer at Moody's in London. "Things just behaved in a way that we were not able to predict." Says S&P's statement: "Our original ratings were based on the best available data at the time." It adds that the credit quality of the CDOs' underlying investments is still strong… S&P's original rating reports on the CDO pools warn that if the portfolios' market values were to fall below certain thresholds, the pools would be required to start selling. Given that the agencies were aware of that possibility, some investors are now skeptical of how closely the agencies were watching over the CDOs, says Alex Roever, a credit market strategist at JPMorgan Securities (JPM ). Mortgage bond prices had fallen steeply in July and early August, yet the agencies issued no warnings that market value triggers might be tripped… In retrospect it's clear that the agencies misread the market risk when they issued their ratings on Mainsail II and Golden Key. Roever says that's forgivable because no one could have known how extraordinary and precipitous the plunge might be. But some others say the agencies should have been more cautious. Recent mortgage bonds included many more adjustable-rate and subprime loans, which carry higher risk and which were backed by homes whose prices had run up sharply--an unsustainable trend. "They were looking at historical data in a brand new ball game with brand new products," says Janet Tavakoli, president of Tavakoli Structured Finance Inc., a Chicago-based consulting firm and longtime critic of the agencies. "You have to understand what you're modeling. That is Statistics 101, and they failed." S&P and Moody's say they did significant stress testing on their models to account for the risk. Another suspected problem: The agencies may have been focusing too narrowly on the price history of mortgage-backed securities, says Christian Stracke, a senior analyst at CreditSights Ltd., a rival bond research firm. In the last few years the volatility of mortgage bonds was low because money was gushing into the sector, and financiers were developing all sorts of new vehicles. "New technology can breed dynamics that artificially depress price volatility, which in turn gives false confidence," says Stracke. Given all of this, the drastic credit downgrades in August "should not have seemed all that implausible," says Stracke. "We know, over and over, that markets get into crises like this. Price volatility on even very safe assets can be high."”

Complex Securitizations Caused Loan Risks to Disconnect Over Time
From The Economist: “…it is hard to overstate the effect that securitisation has had on financial markets. Until the early 1980s, finance hewed to an “originate and hold” model. Banks generally held loans on their balance sheets to maturity; some debts were sold on loan-by-loan, but this market was small and lumpy. This began to give way to an “originate and distribute” model after America's government-sponsored mortgage giants issued the first bonds with payments tied to the cash flows from large pools of loans. Wall Street built on this innovation, and securitisation took off soon after, then paused before exploding in the 1990s. It was given a lift by America's savings-and-loan crisis, which encouraged mortgage lenders to jettison their riskier loans, and by new technologies, such as credit-scoring, that facilitated loan-pooling. Around 56% of America's outstanding residential mortgages were packaged in this way, including more than two-thirds of the subprime loans issued in 2006. Thanks largely to securitisation, global private-debt securities are now far bigger than stockmarkets. Banks have come to see securitisation as an indispensable tool. Global lenders use it to manage their balance sheets, since selling loans frees up capital for new business or for return to shareholders. Small regional banks benefit too. Gone are the days when they had no choice but to place concentrated bets on local housing markets or industry. Now they can offload credits to far-away investors such as insurers and hedge funds, which have an appetite for them. Michael Milken, of junk-bond fame, called securitisation the “democratisation of capital”. Studies suggest that the explosion of this “secondary” market for bank debt has helped to push down borrowing costs for consumers and companies alike. There are other “systemic” gains, too. Subjecting bank loans to valuation by capital markets encourages the efficient use of capital. And the broad distribution of credit risk reduces the risk of any one holder going bust. Even in the midst of turmoil, it is hard to find a banker, regulator or academic who wants to see the clock turned back. But the crisis has exposed cracks in the new model that were hidden or ignored during the credit bubble. The three most glaring are complexity and confusion, a fragmentation of responsibility and the gaming of the regulatory system. Take each in turn. The past few weeks have shown that financiers did not fully understand what they were trading. The boom in derivatives was one of those moments when financial engineering raced ahead of back offices and risk-management departments, leaving them struggling to value or account for their holdings. … it is not uncommon for investors to break their exotic purchases into smaller pieces in order to feed them into their risk-management systems. This brings new risks, particularly that the parts will behave differently from the whole under stress….In a recent paper* on credit derivatives, David Skeel and Frank Partnoy concluded that collateralised debt obligations (CDOs), one of the most common derivatives, are too clever by half. The transaction costs are high, the benefits questionable. They conclude that CDOs are being used to transform existing debt instruments that are accurately priced into new ones that are overvalued. Complexity confuses investors about the risks they are taking on…The lack of transparency plagues the bundling of loans into securities, too. These days, for instance, lenders are less likely to foreclose on defaulting borrowers: in America, less than a quarter of loans 90 days late or more are in foreclosure, compared with three-quarters in the late 1990s, points out Charles Calomiris, of Columbia University. When a late payer gets back on track his loan is once again labelled “current”, and his chequered history does not have to be fully disclosed when the loan goes into a securitised pool. So even the most diligent buyer would struggle to spot that some of the “prime” collateral of mortgage-backed bonds was, in fact, of questionable quality. Investors seeking redress have encountered unforeseen problems. Securitisations are generally structured as “true sales”: the seller wipes its hands of the risk. In practice buyers have some protection. Many contracts allow them to hand back loan pools that sour surprisingly quickly. Some have done just this with the most rancid subprime mortgages, requesting an injection of better-quality loans into the pool. But there were so many bad loans that originators could not oblige. “What we thought was an effective secondary-market punishment mechanism turns out to be faulty when the problem grows beyond a certain size,” …The second lesson of the past few weeks is that securitisation has warped financiers' incentives. It is sometimes portrayed as bank “disintermediation”, but in fact it replaces one middleman with several. In mortgage securitisation, for instance, the lender is supplanted by the broker, the loan originator, the servicer (who collects payments), the investor and the arranger, not to mention the rating agencies and mortgage-bond insurers. This creates what economists call a principal-agent problem. The loan originator has little incentive to vet borrowers carefully because it knows the risk will soon be off its books. The ultimate holder of the risk, the investor, has more reason to care but owns a complex product and is too far down the chain for monitoring to work. For all its flaws, the old bank model resolved the incentives in a simple way. Because loans were kept in-house, banks had every reason both to underwrite cautiously and also to keep tabs on the borrower after the money left the vault. Investors in loan-backed securities could have pushed for tougher monitoring. But most were too taken with the alluring yields on offer…Debt investors are usually sober types, but as the bubble grew, it was increasingly their urges, and not the creditworthiness of homeowners, that determined loan-underwriting standards. Wall Street took full advantage of this appetite. It was well known that investors such as Germany's IKB, a lender to small companies which was bailed out last month, had a weakness for exotic products. The securities firms peddling mortgage-backed bonds did little to disabuse them of the notion that a CDO with a high rating must be as safe as houses—after all, the buyers were sophisticated institutions, not widows or orphans. Moreover Wall Street has every reason to shovel securitised debt out as fast as it can. The loan-origination platform has high fixed costs, so it is a scale business. This can lead to trouble when there are not enough creditworthy new borrowers, as in subprime lending. Banks may be tempted to keep feeding the machine at the expense of laxer lending standards…Complexity and warped incentives foster the third cost of securitisation: gaming the regulations. Politicians are scrutinising the role of rating agencies, as they did with auditors after the dotcom bubble burst. Regulatory dependence on ratings has grown across the board. Banks can reduce the amount of capital they have to set aside if they hold highly rated paper, for instance, and some investors, such as money-market funds, must stick to AAA-rated securities. But not all top-rated paper is the same. The agencies appear to have been too free in giving out prized AAA badges to structured products, especially CDOs. This was partly because their models were faulty, failing to pick up correlations between different markets, and partly because of a conflict of interest: theirs is one of few businesses where the appraiser is paid by the seller, not the buyer. This made it easier for the banks securitising and further repackaging debt to create the greatest possible number of securities with the lowest regulatory cost (that is, highest rating). Investors restricted to investment-grade paper assumed (or at least hoped) that the rating was a guarantee of strength. It might have helped if the agencies had properly monitored their ratings after issuing them. But with low fees per security there is little incentive to stay on the case…. argues that securitisation has let banks (as regulated “holders” of credit risk, with the capacity to keep it through bad times) pass it on to unregulated “traders” of risk with smaller balance sheets, such as hedge funds, which sell when trouble strikes. As a result, he says, although the risk of bank runs has fallen, the risk of market runs has increased…If investors continue to shun the most complex products, Wall Street will have to offer simpler fare. Tom Zimmerman, head of asset-backed research at UBS, sees parallels between the CDO bust and the blow-up in collateralised mortgage obligations (CMOs) in the mid-1990s. CMOs, which pool prepayment risk, became so convoluted that investors could no longer see where the dangers lay. When they stopped buying, investment banks made the product more straightforward and it took off again…But do not expect a rush back to the ways of the 1960s. Securitisation has become far too important for that… the transformation of sticky debt into something more tradable, for all its imperfections, has forged hugely beneficial links between individual borrowers and vast capital markets that were previously out of reach.”

MISC
From The New York Times: “A majority of hedge fund managers say a U.S. recession is "very likely" in 2008, but fewer than one in five said an economic slowdown would be bad for their funds, a survey of several-hundred hedge fund managers released on Tuesday found… 66 percent suggesting a recession would bring investment opportunities… Another 87 percent of those interviewed predicted market volatility would continue or increase for the rest of 2007.”
From JP Morgan: “Sharp declines in aircraft and motor vehicle bookings exaggerated the weakness in August durable goods. But ex transportation orders also reversed a sizable portion of July’s gain. And both ISM and IP softened in August, confirming that the underlying trend in manufacturing activity indeed slipped. More telling has been the moderation in core capital goods orders and shipments, and the risk to our 3Q equipment investment forecast (6%) is clearly to the downside. However, consumer spending is tracking above the anticipated 2.8%. So for now we are leaving the 3Q GDP forecast unchanged at 3%.”

From MNI: “In the first eight months of the year, China had imports of 603.98 bln usd, up 19.6 pct year-on-year…China spending on pollution control was at a record… 1.23 pct of GDP, according to a report released by the environmental regulator, the State Environmental Protection Administration.”

From Morgan Stanley: “The declining birth rate initially yielded a ‘Demographic Dividend’, as the working population rose as a percentage of the total population. In fact, this effect is so dominant that half of the changes in US per capita income growth since 1960 can be explained by changes in this demographic composition of its population.”

From The International Herald Tribune: “Over the past five years alone, oil prices have risen 158 percent, to around $80, while the price of wheat has soared 126 percent. Costs for nickel, used to build … sinks, have shot up 415 percent.”

From Bloomberg: “Bear Stearns Cos. is in ``serious talks with several outside investors'' including Berkshire Hathaway Inc.'s Warren Buffett to sell as much as 20 percent of
the firm, the New York Times reported, citing unidentified people familiar with the matter.”

End-of-Day Market Update

From UBS: “The Treasury auctioned $18 billion in 2-year notes at a yield of 4%, 0.8bp through the 1pm level. The bid-to-cover ratio was solid at 3.29x, although lower than last month's record 3.97x, and indirect bidders accounted for an above-average 35.5%... Swap spreads narrowed about 1.5bps across the board. Agencies saw heavy buying in the front end, especially in maturities between 6 months and 1 year. There was also strong buying of callables, as redemptions forced accounts to reinvest. Coupled with Fannie and Freddie not issuing much lately, the buying interest led agencies to outperform swaps by 0.5bp. Mortgages saw about $1.5 billion in origination, which pushed MBS about 2+ wider on the day. After about $1 billion in buying late in the day, however, mortgages ended only 1 wider.”

From RBSGC: “The [Treasury] market ended the day with a slight bid, but not without trading softer throughout much of the session first… the market bounced on the announcement that Goldman reduced its earnings estimates for Merrill Lynch, attributing the revisions to a potential "multibillion dollar" loss associated with weakness in the mortgage market -- wow. The market gained and equities traded off their highs (although stocks came back). Positions have remained relatively flat throughout much of the recent strength -- somewhat to our surprise. Wednesday's release of the weekly Stone & McCarthy survey shows that this trend has continued -- the index printed at 100.7% of the duration-weighted benchmark, unchanged from last week… Volumes were modest.”

Two and ten year Treasury yields both down less than a basis point in yield today. Two year at 3.98%, ten year at 4.62%.

Equities higher on the day. The Dow is up 100 at 13,878.

Dollar index rebounds today to close up .2, at 78.51, after testing all-time low yesterday by trading at 78.21 vs record low of 78.19. Yen weakened to 115.55, euro remains near record high at 1.413. Gold fell $2.80 to $728.90 spot.

Oil recovered by a dollar to trade at $80.50 at 5pm.