Today's Tidbits

TAF Results
From Morgan Stanley: “The Fed just released the results of the first TAF auction…the key stats are the stop-out rate and the bid-to-cover. The stop-out rate was 4.65% -- right on expectations. The bid-to-cover ratio was 3.1. The results are consistent with the notion that banks have a strong demand for funding at the right price. If the stop-out rate had been above the discount rate (4.75%), it would have conveyed a hint of desperation. Alternatively, a lower bid-to-cover would have signaled a lack of interest in the new program. The results indicated that 93 institutions submitted bids. So, the mean bid per institution was $660 million. This suggests that the bidders probably included a mix of large and small institutions (since the maximum bid amount was $2 billion).”

Declining Homeownership Will Especially Depress Single-Family Demand
From Goldman Sachs: “Although housing starts have already fallen sharply from 2.2 million to less than 1.2 million, we expect a further drop to around 750,000 before a bottom is reached. The declines will likely remain concentrated in the single-family sector, where a declining homeownership rate is weighing heavily on demand and is likely to keep excess supply measures stubbornly high. The fundamental backdrop for multi-family building is better because falling homeownership should ultimately result in rising construction of rental units…Housing activity has plummeted over the past two years. In the single-family sector, housing starts are down 54% over the past two years, the largest decline on record except for the deep recession of the early 1980s. With single-family starts of 829,000 (annualized), roughly 400,000 below the average of the past two decades, one might think that we should now be close to the bottom of the cycle. After all, the homeowner vacancy rate currently stands at 2.7%, roughly 1 percentage point above the average of the past two decades. Since this is equivalent to about 800,000 homes, one could argue that a stabilization at the current level of housing activity would eliminate the supply overhang over a 2-year period. But this logic fails to take account of changes in the homeownership rate. In a falling homeownership environment, single-family housing starts need to fall further below their long-term trend to unwind the excess supply. For example, a trend decline in homeownership of ½ percentage point per year lowers the demand for owner-occupied homes by over 500,000 per year…Thus, we estimate that single-family starts still have substantially further to fall and will bottom around 500,000 (annualized), probably in late 2008. One implication of our analysis is that measures of excess supply such as the homeowner vacancy rate and home inventories are likely to stay elevated over the next few quarters, despite the seemingly depressed levels of housing activity. In particular, the homeowner vacancy rate—our favorite measure of excess supply—is unlikely to fall sharply from its current near-record level of 2.7% until later in 2008. Ultimately, declining homeownership should lead to the construction of more multi-family rental units as a rising percentage of the population rents their accommodation. Nevertheless, we expect some near-term declines in the multi-family sector as well, for three reasons. First, more than half of all multi-family units are built for sale, and this sector is likely to see similar pressures as the single-family market (think Miami condo buildings). Second, the rental vacancy rate currently stands at 9.8%, more than 2 percentage points above the long-term average. This implies a period during which rising demand for rental accommodation may well be accommodated by falling vacancies, without much need for new construction. Third, banks are tightening their standards for commercial real estate loans (which include multifamily construction loans). In the most recent Senior Loan Officers’ survey, a net 50% of all banks reported such a tightening, the largest proportion since 1990. Because of these headwinds for multifamily construction, we expect a sizable decline in this sector as well, from 358,000 (annualized) in November 2007 to around 250,000 in late 2008.”

Falling House Prices Imply Higher Savings Rates
From Merrill Lynch: “…weak demographic fundamentals point to years of sluggish real estate activity, particularly in terms of the "price". The looming dominance of the "move down" buyer suggests that home values will continue to soften long after the building industry mops up the current excess supply. In fact, real estate pricing in general can be expected to be in the doldrums through 2012. The need to save for retirement will have to increasingly come "organically" in the form of setting aside an extra nickel or dime from every dollar earned in after-tax wages and salaries as opposed to what we as a society have been doing for the better part of the past decade, in essence, blurring the distinction between real estate as a "consumption good" (place to live) and real estate as part of the "portfolio" (investment) that was going to experience sustained double-digit appreciation and emerge as a fountain of cash-flow in the future.”

Implications of a “Worse Case” House Crash Scenario on Economy and Banking
From Barclays: “…The banking sector’s exposure to real estate collateral is at an all-time high, while real estate valuations in a large number of economies are similarly at – or just below – all-time highs… real estate loans are 40% of US bank credit, an increase of 10% over the past decade… In the US, the nascent housing futures markets imply a further 15-19% fall in property prices in the 20 main cities through to 2010. These projected losses match or exceed the worst property price declines seen over the past half century… in the US, the largest historical drop in the Case-Shiller price index was in the 1989-91 period, when prices dipped just 4%. Since the peak in 2006, this index has already dropped 6%, with the futures market implying substantial further declines, for a total fall of 21% in house prices. Property futures markets are unequivocally discounting a savage bear market for real estate, anticipating a broad-based decline in prices of 15-30% in the UK and US markets… Overall, the derivative markets are effectively forecasting the worst real estate bear market of the post-war period. Meanwhile, the banking system’s exposure to real estate lending is the highest of the post-war period. It is difficult to construe the coincidental combination of these two factors as positive for banks. Substantial declines in the value of the collateral underpinning the banking system’s largest loan exposures will raise the risk inherent in the sector. More to the point, delinquencies, defaults and write-offs are bound to rise from current levels, if the forward real estate prices prove to be an accurate forecast… Assuming a modest drift up in the unemployment rate to 5% and the 21% decline in house prices forecast in the derivatives market, the regression suggests that the delinquency rate for all residential real estate loans will climb above the previous 1991 peak to a new high of 4%... Overall, if the forward market prices for real estate are an accurate forecast of actual price trends, an accumulation of bad property loans is likely to be a drag on bank profits throughout the next two years. Such an outcome is not priced into banking sector equity prices. As noted earlier, the consensus among analysts is for a deep V-shaped trajectory for bank profits, a sharp recovery beginning as early as next quarter. Indeed, when the bank sector’s 2 year forward PE ratios are considered, it is clear that the stock market has not downgraded the medium-term outlook for bank profitability. In contrast to both the 1989-91 and 1998 credit crunches, US 2 year forward bank PE ratios are just above 70% of the market average. During both previous episodes, bank PE ratios fell to less than half the market average. Falling real estate prices have an implication for economic growth, as well as bank profits. Clearly, a sustained increase in write-offs and losses will persuade banks to be less than eager to extend fresh credit. Exactly such a process is under way at present. However, the general expectation that the present credit drought will be short-lived is contradicted by the implications of forward property prices. If these derivative markets are correct in their gloomy assessment of real estate trends, the credit drought will not ease much when liquidity returns to the money markets but will, in fact, persist to some degree for the next two years. Certainly, if real estate prices decline in the manner foretold by the futures markets, the primary banking system is not going to be in a fit enough condition to fully replace the asset-backed market and associated entities as a source of fresh credit. To a great extent, the secondary banking system that comprised of CDOs, SIVs, Conduits, hedge funds and asset-backed securities has shut down. This sector had been responsible for the majority of lending over the past five years. The collapse of the secondary banking system and the diminution of the originate-and-distribute bank model have left a gap in the process of credit provision. Primary banks, if they are labouring under a burden of real estate bad loans, are unlikely to be willing or able to fill this gap. A drop in real estate prices of the dimensions envisaged by the futures markets also has clear connotations for household wealth and hence for consumption. To quantify this possible effect, we regressed the US household savings rate against the wealth-to-income ratios for household equity holdings and real estate holdings. The resulting equation gives us a rough framework for estimating the possible impact of a shift in wealth on the savings rate. The exercise suggests that if house prices do indeed fall 21% as discounted by the futures market and if equity markets are flat over the same period, there is a 2.25% upward risk for the personal savings rate. Since real personal consumption has averaged a 2.9% growth rate over the last two quarters, if such a rise in the savings rate occurred, a recession would seem to be inevitable. Simply put, house price futures are foretelling a real estate bear market of recession-inducing magnitude. The extent of the property bear market forecast by derivatives is much larger than implicitly assumed in other asset valuations. Neither banking sector equity prices nor indeed equity prices in general appear to be anticipating a 15-30% slide in property prices. Equally, consensus economic forecasts – which cluster round a short-lived US slowdown – are clearly not incorporating a savage 2-to-3 year real estate bear market. This is presumably because the price declines anticipated by the property derivative markets are much larger than the more modest losses foretold by econometric modelling of house price trends. Were economists to adopt the property derivatives forecast of property price trends, the net result would be much weaker and more recessionary expectations for growth. Clearly, the accuracy of derivative market forecasts is far from perfect. Currently, the property derivative markets are dominated by attempts to hedge property exposure and the technicals have been very strongly bearish. However, to some degree, the implicit forecasts may be self-fulfilling, in the sense that lenders might take their cue on real estate credit availability and pricing from the derivative markets… with a global resource scarcity keeping headline inflation rates high, central banks are not in a position to be able to ease aggressively in support of real estate prices. To the extent that rate cuts have obviated past real estate bear markets, this particular comfort blanket is looking distinctly threadbare. The broad point, however, is that property derivative markets – and indeed the price-to-book ratios of property companies – are painting a much more negative picture of the economic and financial future than are other asset markets. An investment theme of selling financial and retail sector equities versus the bombed out property sector or bombed out property derivatives market would appear to make some sense. More generally, the pricing of the property forward market provides us with a strong admonition to be cautious regarding the absence of recessionary pricing in any other asset markets. The combination of extensive real estate price declines and monetary policy circumscribed by high inflation is a particularly toxic mix.”
From Bank of Montreal: “… the Boston Fed’s superb report on subprimes. Among its many statistics: Historically, 20% of homes purchased with subprime mortgages end in foreclosure; in 2006-07, this rose to 30%. During a 20% drop in housing prices, subprime borrowers are fourteen times more likely to default than borrowers in rising markets.”

Many States Fall Behind in Funding Retiree Benefits – Tax Hikes and Service Cuts Likely
From The New York Times: “Almost half of the states have been underfunding their retirement plans for public workers and may have to choose in the years ahead between their pension obligations and other public programs, according to a comprehensive study to be released to the public on Wednesday. All together, the 50 states have promised to pay some $2.7 trillion in pension and retiree health benefits over the next 30 years, according to the Pew Center on the States, which spent more than a year studying the issue. The amount does not include separate retirement plans run by local governments. While some states are managing their costs reasonably well, the center found that others, like New Jersey and West Virginia, have made serious mistakes and are now cutting education and health programs as they struggle with costs incurred decades ago…Unlike companies, state and local governments are not subject to federal pension laws, which set uniform standards for private industry. If a company skips its required pension contributions, it can be required to pay a big excise tax. No comparable enforcement mechanism exists for states. Even in the absence of federal oversight, some states, including Alabama, Arkansas and North Carolina, have been diligently prepaying their retirement obligations, the center found. But others have consistently let their contributions lag behind the amounts needed. The study showed that about half the states fell into each category. Among the states that have fallen behind, some, like Florida and Iowa, have been skimping only slightly. But several — including Illinois, Kansas, Oklahoma, Michigan, New Jersey, Virginia and Washington — have contributed far less than the required amount, year after year. Other states appear to have been fully funding their pension plans, only to run into trouble in the last few years, at which point they started to fall behind. States in this situation include Colorado, Kentucky, Maryland and Ohio…Even in the most extreme cases, Ms. Urahn said, the public may not be aware of any problem because there is always enough money to keep sending out pension checks, and retirees do not complain. But once the money dedicated to pensions starts being depleted faster than it is replenished, financial problems are likely. The further behind a state falls, the more cash it has to come up with each year to catch up. At some point, the ailing retirement system can start to dominate the state’s overall finances, taking cash away from other important programs…The report also noted that besides pensions, most states had promised health benefits to retired public workers and are only now starting to grapple with those costs. Retiree health plans run the gamut, from very rich to bare bones. Some states, like New York, have succeeded in maintaining well-financed pension plans, only to find themselves forced to come up with tens of billions of dollars more, because they promised retiree health care and did not set aside any money to cover that…States cannot turn to Washington for help…”
From Bloomberg: “Wall Street's three-year love affair with debt sold by U.S. states and cities is over. Municipal bonds, whose returns trounced Treasuries and corporate debt from 2004 to 2006, are headed for their worst year since 1999…securities firms reduced their holdings during the third quarter by the largest amount in at least 12 years, data compiled by the Federal Reserve show… Subprime-related losses also hit bond insurance companies that guarantee about half of all U.S. municipal debt, weakening investors' confidence in the AAA corporate ratings that are applied to the obligations and hurting prices last month. Munis returned 3.02 percent this year, compared with 3.85 percent for corporate securities and 8.42 percent for government debt, Merrill indexes show. That's the worst performance since 1999, when state and local government debt lost 6.34 percent. As investors retreated from corporate and asset-backed bonds to the safety of Treasuries, some also sold munis … Yields on 10-year municipal bonds averaged about 93 percent of what the U.S. government pays, compared with 83 percent on average in the two years before August. Investors typically accept lower rates on state and local debt because interest is exempt from taxes…The higher yields relative to Treasuries means local government borrowers pay 34 basis points, or 0.34 percentage point, more in interest than if municipal bond yields had stayed at 83 percent of Treasuries as in the two years ended in July. A 34-basis-point increase on $9.4 billion of bond sales -- the amount local government borrowers including Chicago's O'Hare International Airport have pending over the next 30 days –means about $320 million in additional interest through 2017.”


MISC
From Bloomberg: “U.S. home foreclosures rose 68 percent in November from a year earlier…There were 201,950 foreclosure filings in November, including default notices, auction letters and bank repossessions, down 10 percent from October's total, RealtyTrac reported today. California, Florida and Ohio had the most filings and Nevada had the highest foreclosure rate.”

From Dow Jones: “Morgan Stanley said it is shoring up its capital with a $5 billion investment from China’s sovereign wealth fund after a $9.4 billion write-down related to mortgages pushed the bank into a deep loss for the fourth quarter. The write-downs were primarily the result of a speculative trading bet that went bad, and their scale — more than twice the size of the $3.7 billion hit the bank forecast on Nov. 7 – was a blow to Chief Executive John Mack, who has pushed the firm to boost results by taking on more risk. Mack’s move to sell a stake of just under 10% to China Investment Corp. makes Morgan Stanley the latest damaged U.S. financial institution to seek help from cash-rich funds investing emerging-market government wealth.”

From JP Morgan: “President Trichet today made plain in today’s Parliamentary testimony how much the Council is biased against cutting its policy rate. The latest staff projections see inflation at 2-3% next year, well above the ECB’s target ceiling of 2%, with the risk to these projections "clearly on the upside". These risks include the potential for knock-on effects from high headline inflation to inflation expectations and wages, and also the possibility that food and energy prices might rise further in 2008. The staff continues to forecast growth remaining moderately above trend, although Trichet allowed that the risk to the growth forecast is to the downside. JPMorgan sees ECB policy rates remaining at 4% barring a major threat to growth, believing that against a backdrop of high resource utilization and earlier, pre credit crunch plans to hike rates beyond 4%, the ECB would like to see some slack created in the economy.”

From Bank of Montreal: “The Bank of England minutes from the December meeting showed a surprising 9-to-0 vote to cut rates 25 bps. The MPC acknowledged that there will be some short-term pressure on inflation, but decided that the downside risk to inflation and economic growth in the medium-term warranted pre-emptive action. Tightening credit conditions definitely played a role in the move. “Clear signs of slowing in secured lending to households…tightening in credit conditions faced by firms… increased risk of a more severe reduction in the availability of credit...worsening financial market turmoil, and the consequent tightening of credit conditions, had increased the downside risks to activity and inflation in the medium term.” There were also concerns that the housing market is slowing faster than expected and that consumer spending growth has downshifted in Q4.”

From Bloomberg: “The pound fell below $2 for the first time in three months on speculation the Bank of England will keep cutting interest rates to prevent the global credit crunch from curbing growth in Europe's second-largest economy. The U.K. currency has dropped 4.3 percent versus the dollar since trading at a 26-year high of $2.116 on Nov. 9. This year, it has weakened most against the Brazilian real, declining 14 percent. It's 12 percent lower against the Canadian dollar.”

From SunTrust: “News that S&P has downgraded 6 insurance companies caused a sharp reversal in Treasury prices. MBIA and AMBAC maintained AAA status, but the outlook was lowered to “negative” vs stable. ACA’s rating was cut to CCC from A.”

From Bank of Montreal: “Gold is the only financial asset that is nobody’s liability. That makes it a pure store of value when financial panics are disemboweling risky paper assets—stocks and commercial paper alike.”

From JP Morgan: “Prospects for an increase in conforming loan limits gained ground
this past week, as the Treasury showed support for the idea. At this point, there are a number of supporters of the idea in DC, but the sticking point now appears to be whether the increase can be kept as temporary. The increase will likely follow the bill announced in May, which raised conforming loan limits to the median home price by MSA, up to a maximum of $626,000. Many uncertainties remain, including whether they would be included in the TBA market, or whether there would be a FN/FH Jumbo market. However, if it were to pass, loans with balances between $417,000 and $626,000 are likely to benefit from the improved execution. Under current g-fees, execution as a conventional pass-through is 2-3 points better than as a non-agency pass-through.”

End-of-Day Market Update

From Lehman: “Liquidity seemed to hit a new low on Wednesday when, after a fairly quiet morning session, treasuries went haywire in the afternoon… A little after 1:00 NY time, the market just exploded, with ten year notes rallying 7 basis points in a half hour, and two year notes rallying about 10 bp. There were rumors of a large long end buyer driving the move, but the yield curve did not really flatten that much in the rally, and ten year note futures were strong performers. And then, as quickly as the market rallied, it turned on a dime and sold off, with tens getting within a couple of ticks of the 1:00 levels. Then at 3:00, as if on cue, the market jumped again, with tens evaporating up 10 ticks almost instantaneously. (I say evaporating because I don't think I actually saw them trade between 101-13 and 101-23 on the move.) We didn't really find a plausible explanation for today's whipsaw moves, but it is a reminder (I know, "broken record") of how painfully thin and illiquid markets have become into year end. If you have something big to do, and maybe even something not that big, it seems to cost a lot of basis points to do it… Wednesday's 3:00 yield changes, which were quite different from the 2:00 and 4:00 yield changes, were very roughly as follows:
2 years: -5.6 bp
5 years: -4.3 bp
10 years: -5.8 bp
18 years: -5.5 bp
30 years: -5.8 bp”

From RBSGC: “Volatility was undoubted a theme, as the market's sharp moves in the afternoon were driven by stocks testing some key lows and a generalized anxiety that is extending the common flight-to-quality bid. This is a trend that we do not expect to shift in any meaningful way -- particularly as the long over-due holiday vacations begin and street staffing lightens.”

From UBS: “Swaps saw very good 2-way flow in the belly, and swap spreads tightened across the board after a 6bp intraday roundtrip. Spreads narrowed by 1-2bps in the minutes immediately following the TAF results. Agencies saw buyers in the 5-7 year sector, and sellers of 10-years. The 2-year area cheapened going into the FHLB auction of $4B worth of new 2-years, but the new issue held in versus Libor after pricing at L-23.5. Mortgages saw foreign buying this morning, and were as much as 7 ticks tighter to Treasuries at one point. They have since come off their tights and are 4 tighter on the day.”

From JP Morgan: “Mortgages tightened several bp in LIBOR OAS over the past several days, bringing spreads to average levels for the past six months.”

Three month T-Bill yield fell 13.5 bp to 2.90%.
Two year T-Note yield fell 8 bp to 3.11%
Ten year T-Note yield fell 9 bp to 4.03%
Dow fell 25 to 13,207
S&P 500 fell 2 to 1453
Dollar index rose .17 to 77.59
Yen at 113.43 per dollar
Euro at 1.438
Gold unch at $802
Oil rose $1.17 to $91.25
*All prices as of 4:25pm