Vacant Homes on the Rise as Homeownership Rate Falls to 2003 Level

Both rental and homeowner vacancy rates rose in the third quarter. The homeowner vacancy rate, at 2.7%, is just below the record high of 2.8% set in the first quarter of 2007. Rental vacancy rose from 9.5% in the second quarter to 9.8% in the third quarter. A high number of vacant homes is a strong indicator that there is still plenty of excess supply in the housing market, and will likely maintain continued downward pressure on house and rental prices.

Homeownership rates continued to decline, falling to 68.1% from 68.3% in the second quarter, the lowest level since 2003. The high was reached in 2005 at 69%. In absolute numbers, this quarter's decline indicates around 900k households moved from owning a home to renting on an annual basis. This is a large number in relation to new home sales, which are currently running at less than 800k annually.

U of Michigan Consumer Sentiment Falls Again

The final University of Michigan confidence index reading for October unexpectedly dropped to 80.9 from the previous estimate of 82. Rising oil prices and the continuing housing slump are being blamed for the index reaching the lowest level since May 2006.

A steady job market and higher wages have supported confidence and spending so far, but the trend is not looking healthy. Future expectations fell from 74.1 to 70.1, indicating that consumers are likely to become more cautious. Current conditions only fell slightly to 97.6 from 97.9.

One year inflation expectations held steady at 3.1%, with five year inflation expectations running at 2.8%.

Initial Unemployment Claims Remain Elevated

After last week's spike higher in unemployment claims to 337k, a six month high, this week we saw only half the retracement that was anticipated by the market. Claims fell back to 331k (consensus 320k). The four week moving average has now moved up to 325k from only 310k three weeks ago. Continuing claims rose +.3% to 2.53 million.

This data will encourage thoughts that the slowing economy is beginning to impact the labor markets, and that last week's rise was not due solely to the Columbus Day holiday.

Durable Goods Orders Unexpectedly Slump -1.7% MoM in September

Orders for Durable Goods continued to decline in September. The market had been looking for a rebound of +1.5% MoM following the revised worse -5.3% MoM drop in August. Instead, orders fell an additional -1.7% MoM in September (-8.4% YoY).

Demand for business equipment did rise, but surprisingly military demand slumped. If defense orders, which fell -39% MoM and are down -63% YoY, are excluded, durable goods orders rose +.7% MoM. Rising machinery (+4.3% MoM) and computer demand (+1.1% MoM) suggest companies continue to invest in capital improvements, though overall capital goods orders fell -1.3% MoM, and are down -19.5% YoY. The majority of the decline has been in non-defense, which has fallen -12% YoY. The auto sector remains weak, falling another -2.9% in September, after dropping -8.2% in August. Auto companies continue to scale back production. Demand for construction equipment has definitely eased as the housing market slows.

Transportation orders fell -6.3% MoM and are down -23% YoY. Excluding transportation , which tend to be volatile because of the airliner demand, orders rose a smaller than expected +.3% MoM (consensus +.7%), and are only down -1.2% YoY. Orders for commercial aircraft rose 18% in September after dropping -41% in August. Boeing continues to work through a record order backlog as demand for transportation in emerging economies, such as China, expands rapidly.

Shipments fell -2% MoM and are down -1.1% YoY. This is the second month in a row that shipments have declined, and is primarily driven by lower vehicle demand. The largest declines in shipments were in semiconductors (-16% MoM), transportation (-5% MoM) in both autos and aircraft, and defense (-4.6% MoM).

Inventories rose +.4% MoM and are up +2.8% YoY. Unfilled orders rose +1.6% MoM (+18% YoY) with most of the increase in non-defense capital goods which are up +31% YoY. The inventory-to-shipments ration rose to 1.48 from 1.45 the prior month. The low for the past six months was 1.42 in July. Not clear if this renewed inventory accumulation is desired or not.

Net, the headline figure was much weaker than expected, and shows a continuing slump in demand as credit conditions have tightened. The bright spot was continued growth in demand for core capital goods (excludes defense and aircraft). The Fed will pay attention to signs of slowing consumer and business spending.

New Orders for Durable Goods, Yr/Yr%

Existing Home Sales Fell a Larger Than Expected 8% MoM in September

Existing home sales fell to the lowest level since records began in 1999. The 8% MoM decline was almost double the -4.5% drop that was anticipated. Single-family home sales fell -8.6% MoM, while multi-family sales fell a more moderate -4.3% MoM. The supply of homes rose to 10.5 months, at the current sales pace, also another record low since records began in 1999. By category, singly family inventory is running at 10.2 months and multi-family (condos, townhouses, etc) is up to 12.6 months of supply.

Both median and average prices fell in September. Median home prices dropped by -4.2% YoY to $211,700 while average home prices fell by -3.2% YoY to $257,800. In both categories, condos/coop prices are higher than single-family prices. All of the decline happened in single family pricing, while multifamily rose around +1.5% YoY. Next week's Case-Shiller data is expected to provide better quality data on home price declines. Today's series of data is more dependent on a changing mix of homes being bought and sold during the month, rather than comparing repeat sales of the same homes.

By region, sales fell -12%MoM in the West, followed by an -11.1% decline in the Northeast, -7.9% fall in the Midwest, and a -6.5% drop in the South. Versus a year ago, sales have fallen -11.4% in the Midwest, followed by a -9.9% drop in the West, a -8.9% decline in the Northeast, and a -7.2% back-up in the South. Prices fell in all regions of the country. The most expensive region remains the West, where the average price was $354K in September. The least expensive region is the Midwest at $199K.

Existing home sales lag actually original contract signings by 1-2 months, on average. So this data shows the beginning of the intensifying subprime problems of July and early August, but most likely not the worst of the fallout. Pending home sales fell -6.5% MoM in August after falling -11% MoM in July. Most economists are expecting further deterioration in home sales following the credit crunch which began this past summer. The MBA estimates that new mortgage volume this year will fall to the lowest level since 2000. It looks like housing will remain a drag on the economy for a while. The fed funds futures market is pricing in a 98% probability the Fed will ease by 25bp next week (Halloween). Tomorrow we get September new home sales data, which are currently predicted to fall by -3.1% MoM after declining -8.3% MoM in August. New home sales data is considered to be more timely than existing home sales data.

Today's Tidbits

Indicators of Economic Health
From Deutsche Bank: “Right now there are three indicators which we are watching closely to gauge recession risks: jobless claims, consumer confidence and the ISM. Jobless claims have been very low despite softer job gains and slowing GDP growth. The reason claims have stayed low is because most of the slowdown in GDP growth has been due to lower productivity. Corporations have hoarded labor even while economic activity slowed. As a result, the labor market has remained tight and income growth has stayed solid, running between 6%-7%. Incidentally, this is corroborated by the employee tax receipt data, which after looking soft in August, have since rebounded. Tax receipts suggest that robust income growth will continue, at least in the very near-term. In this environment, consumer confidence should hold up. We prefer the University of Michigan sentiment survey because its questions change from month to month, making it less static than the Conference Board's consumer confidence survey. Despite strong income growth, consumer sentiment has been stuck in the low 80s over the last few months. While consumer attitudes are a notoriously unreliable gauge of consumer spending, large moves in the former tend to correlate well with meaningful changes in the latter. As long as sentiment stays in the mid-to-high 80s and does not crack on the continued drumbeat of negative housing news, the economy should be okay. If this is the case, then business confidence, which is proxied quite well by the ISM survey, should hold up well. We will start to worry about the economic outlook if any of the following data thresholds are breached: jobless claims rise above 350k, consumer sentiment falls below 75, or the ISM survey prints in sub-50 territory.”

Fed Remains Focused on Risk Management
From JP Morgan: “Chairman Bernanke did not break any new ground on the outlook in his two speeches last week. But in both speeches he emphasized the Fed's role as a risk manager. His talk in St. Louis was perhaps the more enlightening one in this regard. His topic was somewhat academic with a central focus on the "Brainard uncertainly principle." This principle holds that it is optimal for monetary policy to move cautiously under uncertainty -- as it is appropriate to walk slowly when in a dark room. Bernanke noted that theoretical developments over the past ten years suggest that this principle may not always hold and there are circumstances where "intuition suggests that stronger action by the central bank may be warranted to prevent particularly costly outcomes." While these comments were partly designed to justify the Fed's September action, he did not frame the speech to limit this point to past actions. It is worth noting that other Fed speakers -- including Chicago Fed President Evans in his first speech in this role -- have also highlighted that the Fed's role as a risk manager warrants preemptive action. In a related development, Governor Mishkin delivered a speech defending the Fed's focus on core inflation in a world in which food and energy prices are rising. The message coming from Chairman Bernanke and others is that the Fed's risk management strategy warrants a further ease in October.”

Fed Adds Substantial Liquidity to Markets This Week
From Dow Jones: “The Federal Reserve has added a fairly substantial amount of liquidity to the financial system over the last three days. While the size of Fed operations is highly variable and driven by diverse factors, operations on Monday, Tuesday and Wednesday were nevertheless hefty. And because of their sizes, the interventions raised the specter of continued troubles in short-term funding markets, although that possibility was complicated by the fact the central bank’s overnight target rate has been sticking fairly close to where it should be, around 4.75%. That suggests at least in the fed funds market, borrowing and lending are functioning as they should. Still, on Monday the Fed took in a substantial $10.5 billion in collateral overnight. Tuesday saw a two-day operation that injected $8.5 billion in fresh cash, followed by Wednesday’s $6.5 billion overnight operation.”

China Faces Growing Energy Demands for Industry and Citizens
From Barclays: “…benchmark coal prices in China hit all-time highs…The real problem for China… is that despite rapid increases in coal production this decade, surging domestic demand is outpacing local primary energy supply, leading to a rapidly widening energy gap… For the first nine months of this year, China’s coal imports have risen by 48% Y/Y… China’s oil imports have continued to soar, driven by rapid growth in demand for transport fuel. Its oil imports hit an all-time high in July of 3.49mn bpd and are up 16% in the year to September. Chinese officials may be complaining that oil prices are too high, but that is not the case for local consumers, who have seen retail prices frozen since May 2007 and hence have little incentive to economise. Strong oil demand growth is contributing to the widening energy gap that China is facing and which has trebled since the start of this decade to the equivalent of almost 3.3mn bpd of oil in 2006. The difficult consequences of this energy gap are recognised by central government, which has started to make life much harder for energy intensive industries, recently reducing electricity price subsidies for ferro-alloy and primary aluminium producers, many of which are big exporters of their products. Nevertheless, with Chinese energy consumption per capita currently at the equivalent of just 9 barrels of oil per head per year (the equivalent figure for the US is 59), the nation faces a big struggle to prevent a further widening of its energy gap in the years to come.”

MISC

From Citi: “…With 2s trading at 3.81%, the lowest yield seen in 2yrs, and still 69bp below the 4.50% Funds rate …it will be difficult to rally much further unless we start to see the very front end start pricing in the possibility of the Fed eventually going beyond 4%.”

From Goldman Sachs: “Manufacturing activity appears to have decelerated further over the past month. Three reports released over the past week have suggested that orders and shipments of manufactured goods are growing more slowly than before…”

From Merrill Lynch: “The National Retail Federation expects that holiday sales could be the slowest in five years at just 3.7%. On top of this, yesterday UPS lowered guidance for 4Q, citing concerns about weak retail sales. And we don’t see much momentum going into the holiday season – the latest chain store sales are anemic, running at just above 2%.”

From Deutsche Bank: “We are worried that the housing market slide may be accelerating. There was evidence of this in last week's figures on new residential construction starts; the 6-month rate of change (-36%) showed a steeper decline than the year-on-year rate (-31%), and the 3-month rate of decline was even lower (-57%). There is a 10 month supply of inventory in the new construction market, which is a record high and over twice as large it was during 2004 and 2005.”

From RBSGC: “As we have discussed many times, we are not big fans of the price numbers in this release[existing homes] because the price composition of homes sold in any given month tends to fluctuate wildly. The disruptions seen in the financing markets this summer probably distorted the price numbers down in September (the median sales price plunged by nearly 6% in the month) because the jumbo market -- by definition, expensive homes -- dried up for a time. Undoubtedly, prices are falling in a variety of regions, as they need to for those markets to clear, but this particular reading should be viewed skeptically.”

From Dow Jones: ““There’s no question that housing is the area we’re most concerned about,” Al Hubbard, director of the White House’s National Economic Council, told CNBC. “There’s significant softness in housing and to be perfectly frank...it’s not going to turn around quickly.” Edward Lazear, chairman of the Council of Economic Advisers, said declines in the housing market haven’t had much of an impact yet on consumption, largely because the market’s problems followed a big appreciation in home prices.”

From Morgan Stanley: “Stripping out the China gap still leaves a US trade deficit of over $600 billion in 2006 – a number nearly three times as large as the shortfall with China… If America wants to fix its trade deficit and relieve the concomitant pressures that are bearing down on middle-class workers, it must address its seemingly chronic saving deficit.”

From SunTrust: “Merrill's Q3 earnings are not pretty. Merrill reported its first quarterly loss in 6 years and increased their writedown for sub-prime and asset- backed bonds to $7.9 bln, over $2 bln more than expected. The additional loss was written down after "additional analysis and price verification". Now the concern is there will be more to come in Q4 as further "price discovery" unfolds.”

From Deutsche Bank: Observations from a recent conference] “A sharp contrast was noted on the US outlook between relatively benign views outlined by the main opinion makers and a rather alarmed tone detected among investors. This, however, seems to reflect unusually asymmetric downside risks and their associated effect on asset pricing.”


End-of-Day Market Update

From RBSGC: “Bonds had a strong rally and attempted technical break, with 3s the best performer, as 'bad' information proved even worse than expectations. Existing Home Sls fell a whopping 8% with inventory at the highest level in 22 years and prices fell sharply -- led by single family units. Single family home prices fell 4.9% -- most on record. And while rumors were around on Tuesday that Merrill had deeper Q3 writedowns coming, the 7.9 bn amount announced today along with EPS at -$2.85 were worse than expectations (-$0.45 was expected for EPS). The move up came on decent volume and accelerated post the Existing Home Sls report pointing to new buyers and some momentum coming to the market. In accord, Fed Fund futures for November have moved fully to the 25 bp camp AND added some odds towards either a 50 bp move (either 14% for next week, or somewhat less for sometime in Nov in what would be an inter-meeting event). This action reeks of a bit of panic (and stock charts look particularly ugly) with some covering afoot.”

From UBS: “The 2s30s curve steepened nearly 5 more basis points on increased expectations of a rate cut next week … Spreads were wider intraday, but ended the session little changed. Agencies saw overseas selling of 3- and 10-year notes, and lagged swaps by 0.5bp across the board…Mortgages saw decent 2-way flow, trading in line to a plus wider on the day.”

From Deutsche Bank: “…all recent resistant points taken by 11:00. real money types particularly engaged buying often and early across mbs and trsy space. 2yr raffle on the screws but little fanfare. afternoon equity reversal almost surreal with a third probe of recent lows finding massive buy interest. number of large mutual funds have oct year end so not overly shocked to see some committment to defend 15%ish yoy gains in the dow.”

From SunTrust: “Equites have cut their losses from -205 points to -22 points, but Treasuries are still hanging around the highs of the day. One reason the bond market will not release on its relentless bid is expectation that another investment bank is about to announce a horrendous writedown. Rumor is Lehman, the amount is for a loss of $9 bln. Lehman has denied any such loss.”

From JP Morgan: “Rumor of possible discount rate cut helped stocks bounce”

Three month T-Bill yield fell 12.5bp to 3.85%.
Two year T-Note yield fell 8.5bp to 3.73%
Ten year T-Note yield fell 7bp to 4.33%
Dow fell 1 to 13,675
S&P 500 fell 4 to 1516
Dollar index fell -.07 to 77.51
Yen improved to .5 yen to 114.25 per dollar
Euro closed unchanged at 1.427
Gold rallied $3.60 to $763.5
Oil rose $2.33 to $87.59 (all prices as of 4:45)

Today's Tidbits

Countrywide Offers to Renegotiate Subprime Loans for Current Customers
From Bloomberg: “Countrywide Financial Corp., the biggest U.S. mortgage lender, plans to refinance or restructure as much as $16 billion of debt for home buyers facing higher payments on adjustable-rate mortgages before the end of 2008. Countrywide has already refinanced $5 billion of loans and plans to contact 52,000 subprime borrowers with $10 billion of debt to offer new loans…It may modify terms on as much as $6.2 billion of mortgages for borrowers ineligible for refinancing…``Countrywide believes that none of our subprime borrowers that have demonstrated the ability to make payments should lose their home to foreclosure solely as a result of a rate reset,'' David Sambol, the company's president and chief operating officer, said in the statement.”

Chapter 13 Bankruptcies Rise as Homeowners Struggle to Delay Home Foreclosure
From The Wall Street Journal: “Most consumers filing for bankruptcy continue to do so under Chapter 7 of the federal Bankruptcy Code. Under that provision, a person must forfeit certain assets -- including, in some cases, a portion of home equity. Those assets are sold to pay off debts. While Chapter 7 filings stop foreclosure proceedings, the break is usually only temporary. As a practical matter, many homeowners who file under Chapter 7 lose their homes. In recent months, however, an increasing number of homeowners have filed for bankruptcy under Chapter 13, which staves off foreclosure proceedings while the homeowner works out a plan to pay off mortgage debt and other obligations over time -- usually three to five years. To qualify, debtors must have a regular income and must stay current on their new bills. About four in 10 filers today are filing under Chapter 13 -- up from three in 10 two years ago. The 2005 change in bankruptcy laws was designed in part to shift more filers to Chapter 13, which forgives less debt than Chapter 7. In California, one of the nation's hottest markets during the recent real-estate boom, the number of nonbusiness Chapter 13 petitions in the second quarter of the year more than doubled from a year earlier, according to records compiled by the Administrative Office of the U.S. Courts in Washington. Over the same period, such filings increased nearly 40% in the northern district of Illinois, which includes Chicago, and 70% in Massachusetts…it isn't a strategy that works for everyone. Consumer advocates say the homeowners who are most likely to benefit from Chapter 13 are those facing foreclosure because of a temporary financial setback, but who expect to be able to cover their mortgage payments in the future.

Russia’s Booming Economy Dependent on Immigrant Labor as Population Shrinks
From Bloomberg: “As Russia's booming economy creates greater wealth and aspirations among its citizens…A shrinking local workforce complicates matters, as oil- powered economic growth fuels demand for offices, apartments and shopping malls -- along with people to build and maintain them. ``There is such a deficit of labor all over Russia, just at a time when Russia has woken up,''…Russian economic growth has averaged 6.7 percent a year since 1999. Meanwhile, Russia's population fell to 143.8 million in 2006 from 148.7 million in 1992 and continues to slide by almost 1 million a year, government statistics show. The workforce decline is dramatic. According to the Health and Social Development Ministry, it will drop 12 percent to 65.5 million by 2010 from 74.5 million now because of low fertility rates and the high number of alcohol-related deaths. Mikhailov says 40 percent of his farm and construction workers are foreigners, many of them of Muslims who don't drink. …Life expectancy for Russian men is 59 years… Russia is home to the world's second-largest number of immigrants, after the U.S.”

Disarray in Mortgage Financing Enabling Identity Theft Risk to Rise Substantially
From The Wall Street Journal: “…inside the complex's Dumpster: a cache of 40 boxes of loan files containing Social Security numbers, credit reports and other data on customers of Ameriquest Mortgage Co….Privacy experts say this sort of mishap -- which leaves borrowers vulnerable to identity theft -- is a growing concern in the mortgage industry. The mortgage process has become more complex, with consumer information flowing through the hands of a menagerie of independent brokers, itinerant loan officers, investors and financial middlemen. With the housing downturn forcing many of these firms to sack workers and shut branches, some mortgage files are getting lost in the shuffle, turning up in places like Dumpsters that are easily accessed by scam artists. "In times of organizational change or chaos, we're much more likely to see those kinds of leaks -- what I call inadvertent disclosures," Dartmouth College management professor Eric Johnson says. Experts say that putting numbers on how frequently confidential mortgage data is leaked is difficult, because many breaches go unnoticed. In July, however, Bob Segall, a reporter at WTHR-TV in Indianapolis, tried to get a sense of how bad the problem was around central Indiana. Over three days, he peered into 40 Dumpsters behind loan branches and title companies that handle mortgage documents. In nearly half -- 18 -- he discovered sensitive information about borrowers. "You could see their complete financial lives on paper, dating back 20, 30, 40 years," he said. Among the finds inside the mortgage files: a letter from one borrower's counselor saying he was doing well in alcohol rehab.”

Progress on Basel II Capital Rules for U.S. Banks
From Dow Jones: “U.S. and foreign bank regulators announced major progress this week related to pending international capital standards known as Basel II…Still, it appears likely that U.S. banks might not be able to adopt Basel II until sometime after the planned Jan. 1, 2008, start date, even on a trial-run basis. The Basel II standards are international capital rules that attempt to more closely align a bank’s risk with the capital it holds to protect against losses. Basel II would update a 1988 international capital framework that many banks and regulators have said is outdated. But because Basel II is so complex, critics have questioned whether it could have an unexpected impact on the safety and soundness of banks. This is one reason why it took U.S. regulators several years to agree on how Basel II should work for large banks, such as Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. The OCC, Federal Reserve, and other regulators finally reached a general agreement in July, and Dugan said Tuesday that regulators translated that agreement into the actual text of a final rule this month.”

MISC

From Deutsche Bank: “An anonymous senior Fed official gave an interview to several news services stating that the Fed did indeed support the M-LEC proposal. Still, the approval was lukewarm, given the anonymity and the lack of detailed support points. The bottom line is who will take the losses on the old SIV assets. A clear public auction process to establish market prices would be helpful, but it will still mean that either the SIV investors or the supporting bank would have to take the losses. The participation of a highly capitalized M-LEC would avoid having the bank absorb the assets on balance sheet.”

From Market News: “China has begun laying a 500 mln usd fiber optic cable to the US that will be vital in meeting booming Internet traffic between the two nations…”

From Merrill Lynch: “The bullish case for commodities is largely based on global supply and demand imbalances. Rarely, however, does one hear about the weak dollar's contribution to commodity returns. It appears as though the weak dollar may be contributing as much, if not more, to the commodity story than is global growth. In fact, some commodity index returns during the past year are actually negative in some currencies!”

From Handelsbanken: “The dollar is down by over 7.7% against the yen since the middle of June, and over 6% against the euro over this same period. The trade-weighted value of the dollar has dropped a full 6.7% since June 14…This broad- based decline in the dollar appears to be the result of a decline in both investors’ confidence in the sustainability of the ongoing expansion and in the Fed’s inflation-fighting credibility. The meltdown in the sub-prime mortgage market and the associated FOMC decision to cut rates are key factors behind the bearish dollar sentiment evident in the currency markets…The dollar is likely to come under renewed selling if the Fed cut cutes rates by more than the 25 basis points already priced into forward rates.”

From Barclays: “While risk took a hit last week, it is worth noting that the BRIC markets and their corresponding bull trends have not yet had any material chart damage. These indices are, however, teetering above important support zones”

From Citi: “Each month the Labor Dept. reports the number of firms engaged in "mass layoffs" which are job purges of 50 or more people…the frequency of such layoffs rose by 81 in September versus August. That's about a 7% month-on-month rise. Rising layoffs are not surprising given the ongoing downturn in housing and related areas. We're already leaning toward a 70,000-ish payroll number for October and this report is broadly consistent with that estimate.”

From Credit Suisse: “Weakening earnings (for now mostly contained to financials) raises the risk of reduced labor demand as companies move to cut costs… In general, turning points in earnings revision momentum leads turning points in labor income by six months.”

From Dow Jones: “Target Corp.’s weaker October sales forecast … now expects sales at stores open at least one year to be up 2% to 4% for the month, citing “greater than normal daily volatility and continued disappointing sales results for the first two weeks.””

From Bloomberg: “Wal-Mart Stores Inc., the world's largest retailer, reduced its capital spending forecast for the second time this year as the company seeks to counter slowing
sales growth in the U.S….The retailer said in June it would scale back the number of new supercenters it opens by a third,…”

End-of-Day Market Update

Very quiet day. Treasury curve steepened as two year yields (-3.5bp to 3.82%) fell more than ten year yields (-1bp to 4.40%). Swap spreads

Equities rebounded with the Dow closing up 109 at 13,676 and the S&P 500 closing up 45 at 2799.

The dollar index gave up much of yesterday’s strength, following the G7 meeting over the weekend, to close down -.5 at 77.56. Gold gained back about half of yesterday’s loss to close up $5.75 at $760.

Oil continued to retreat, falling to $85.30.

Today's Tidbits

Fed Study Indicates Low Down Payment Loans Fueled Housing Boom
From BusinessWeek: “…the national rate of homeownership suddenly began rising around 1995. The rush to buy homes fueled an enormous surge in housing construction and home prices…. new research published by the Federal Reserve Bank of Atlanta concludes that the bulk of the increase was caused by innovations in the mortgage market, in particular the explosion of "piggyback" or "combo" loans that made it possible for people to make small or zero down payments. Young families with little savings flocked to those loans to buy first homes… Using math-heavy econometric analysis, the authors conclude that the availability of new kinds of mortgages, mainly ones with low down payments, accounted for 56% to 70% of the decade-long increase in the U.S. homeownership rate, while demographic changes accounted for only 16% to 31% of the effect. A combo loan such as those mentioned in the Atlanta Fed paper consists of two loans, one for 80% of the value of the house and the other for 10%, 15%, or even the entire 20% remaining. The reason for taking two loans instead of one big one is that 80% is ordinarily the maximum loan-to-value ratio for loans that are eligible for purchase by Fannie Mae and Freddie Mac. When the borrower makes little or no down payment, he or she is more likely to walk away from the loan if the house loses value and return to being a renter. But could the homeownership rate actually decline? Yes. In fact, it already has begun to. According to the Census Bureau, it was 68.2% in the second quarter of 2007, down from 69.2% in the fourth quarter of 2004 and 69.1% in the first quarter of 2005. Goldman's Hatzius says that "given the current number of U.S. households of 110 million, the change in the homeownership rate over the past two years has already subtracted almost 500,000 from the underlying demand for new homes."

More on Impact of Housing Market Slowdown on Economy
From Merrill Lynch: “The Flow of Funds report released last month showed that that homeowners' real estate equity declined in 2Q by 0.22% (annualized) from 1Q and is up just 0.9% from one year ago. This is the slowest yearly pace of real estate wealth accumulation since 1993. Clearly the recession in the housing market is taking its toll. However, even these sluggish numbers, which are based on the relatively narrow OFHEO measure of home prices, may be overstating the true state of real estate wealth in our opinion.”
From Market News: “The WSJ carries an article, saying home prices in some of Europe's hottest markets are falling after a decade of double-digit-percentage price increases, noting the reasons resemble those across the Atlantic: higher interest rates, faltering confidence and tighter lending standards.”
From Barclays: “Homebuilders are priced for a depression. Some have price-to-books at below 0.5. It used to be that price-to-books at 1 were considered cheap. The pricing suggests a further decrease (from today) of 205-30% or more in housing rices…financials are priced to a low PE (8-12 range for many) mainly because the market believes that their profit growth is unsustainable and that there will be some giveback…although, if the homebuilders are right on a depression, Wall Street may be expensive.”
From the Financial Times: “Banks are adding to reserves not just for defaults on mortgages, but also on home equity loans, car loans and credit cards.”

From Bloomberg: “Countrywide Financial Corp., IndyMac Bancorp Inc. and Washington Mutual Inc. were downgraded by Lehman Brothers Holdings Inc. analyst Bruce Harting, who said their share prices don't reflect ``the worst of their problems.''”
From Deutsche Bank: “The last time housing starts were as low as they were in Q3 2007, was during a temporary dip in Q2 1995 or on a more sustained basis in the first half of 1993. Residential construction payrolls at those respective times were only 64% and 58% of the current level*, so we will not be surprised to see significant layoffs over the next several months as the size of the construction workforce falls to a level more consistent with the pace of activity. (*It is important to note these figures correspond purely to residential construction, because there was no data on specialty trade contractors in the residential sector published at that time.)”

Estimating Negative Impact of Higher Oil Prices on Economic Growth
From JP Morgan: “We expect higher fuel prices to take a little less than 1% point off annualized real income growth this quarter and, by itself, reduce real consumer spending growth about one half that amount. Combined with the effects of a softening labor
market and tighter credit standards, real consumer spending growth looks set to slow from a projected 3.5% pace at an annual rate in 3Q07 to 1.8% in the current quarter…The slowdown in consumer spending is coming at the same time that the downturn in housing is intensifying and that business spending on fixed investment is moderating. The result is a marked slowing in real GDP growth from an estimated pace of 3.2%q/q, saar last quarter to a forecast 2.0% in the current quarter. At the same time, headline inflation
is increasing. And the combination of passthrough from higher fuel prices and from the weaker dollar threatens to push up core inflation as well.”
From Merrill Lynch: “Ninety dollar oil is going to extract a lot of pain in the coming months… if the new range is $90+ then we are talking about a 1.25 percentage point drag on real GDP growth – at a time when the trend is barely 2%. We have built half that drag into our 1.5% GDP call for next year. But clearly, this oil drag, coupled with the spread of the housing recession, clouds the outlook in a very material way.”

Are Foreign Equity and Commodity Markets Ready for a Correction?
From Credit Suisse: “…emerging market equities hardly noticed the credit crisis, and China related equities have been on a moonshot, with A shares now 40% higher than they were in late July, and the Hang Seng about 20% higher. Reinforcing the message, Baltic Freight (Dry Bulk) has doubled since mid-June, oil and gold have made new highs and copper seems poised to do so…In each of the last two weeks inflows into EM equity funds have been above 5bn dollars, which has never happened before, with about half of that money going into Asian equities. On a 4-week rolling basis, net flows into GEM equity funds have reached an alltime high…the Chinese communist party is holding its crucial five-yearly congress. With inflation expectations and wages in China apparently picking up sharply and accelerated price gains in both equities and property, there must be serious risk of another round of policy tightening once the congress is over. So just when you thought it was safe to go back in the water, it looks as though we are setting ourselves up for another shock in financial markets, as some of the froth comes out of the emerging equity, and most especially, the Asian equity complex.”
From Merrill Lynch: “Europe down more than 1.5% across the board today - Commerzbank's CEO Mueller on the tapes saying that subprime provisions "won't be enough". Asia was very weak, with the Nikkei down 375 points (-2.2%) to 16,438 and the Hang Seng pummeled 1,091 points or 3.7% to 28,374 in the sharpest falloff (point-wise) in seven years. The Korean Kospi lost 3.4% and even the high-flying Chinese market succumbed to the global contagion via a hefty 2.8% slide (Taiwan reported a surprising uptick in its unemployment rate today to a 3-month high). US futures are down size at this moment - the S&P 500 is now down 4.1% after testing that peak back on October 9th. If there is one asset class that is not buckling (outside of high-quality bonds), it is the commodity complex - and for one reason why that is the case, have a look at the front page article in today's WSJ titled "Ship Shortage Pushes Up Prices of Raw Materials". There is a chronic shortage of bulk ships everywhere, which is why the Baltic Dry Index has doubled in just the past four months after hitting a record high on Friday.”
From Barclays: “China is prices as though super-charged GDP growth is here to stay.”

Recent Bank Balance Sheet Changes
From RBSGC: “MBS holdings by US banks decreased $4 bn with pass-through holdings down $3 bn and CMO holdings little changed. MBS holdings were down $38 bn since the start of this year. Deposits increased $30 bn over the past week. Since the start of this year, deposits increased $313 bn. Commercial and industrial loans increased $13 bn for all banks over the week. Since the start of the year, C&I loans increased $178 bn. Whole loan holdings increased $8 bn over the week. Since the beginning of the year, whole loan holdings increased by $117 bn.”

MISC
From Merrill Lynch: “…rare is the day that earnings are heading south and the market isn't doing likewise.”

From Barclays: “…the credit markets remain in need of a real capital infusion.”

From Merrill Lynch: “the G7 does not appear to have the appetite to change FX dynamics. That could well open the door for extended USD weakness.”

Bank of America: “The Treasury seems to be showing a preference for liquidity in 2yr notes than bills.”

From Dow Jones: “Federal Deposit Insurance Corp. Chairman Sheila Bair said that bank regulators are concerned about the damage that the current credit crisis is having on banks’ reputations. Regulators are discussing whether banks may need to boost their capital to guard against depositor concern about off-balance- sheet and other risks, Bair said after a talk in New York. “It needs to go beyond what we’re already doing,” Bair said. The issue is not so much about banks depleting their regulatory capital ratio, which requires certain levels of cash to insulate them from unexpected market turbulence, as it is their need to reassure depositors that they aren’t hiding assets off their balance sheets, she said.”

From Macroeconomic Advisors: “There was a substantial shift in sentiment in financial markets this [past] week…developments led to a massive rally in Treasury securities, as investors revised down their expected path of monetary policy through 2008 by nearly one-half percentage point. That revision resulted in a 43-basis-point decline in the two-year Treasury yield over the week (to 3.80%) and a 29-basis-point decline in the ten-year yield (to 4.41%).”
From Merrill Lynch: “…not since 1960 have we entered a Fed easing cycle and possible recession with inflation – both headline and core – as low as it is today. We see that that the flurry of buying action at the front end has taken the 2-year note yield down to levels not seen since the aftermath of Katrina in September 2005.”

From Merrill Lynch: “A just released NABE (National Association of Business Economists) survey shows there to be more skunks at the picnic: 56% of businesses polled are more pessimistic now – double the share in July – and for the first time since 2002, the majority believe that GDP growth will come below 2% for the USA in the coming year. Net hiring intentions receded to 17% from 24% three months ago. Capex plans slipped from 50% saying “yes” to now just 43%. Fully 36% say that the tightening in credit guidelines is negatively affecting their businesses.”

From Goldman Sachs: “One sector that has helped offset the housing slump so far is nonresidential construction. Both private and government building have been buoyant, offsetting roughly half of the impact of the residential downturn on real GDP growth over the past year. However, many of the same conditions that drove residential housing activity to unsustainable levels—easy credit, financial innovation, an influx of new buyers with investment motives—have contributed to the boom in the nonresidential sector. With these conditions now in retreat, growth in nonresidential construction is apt to slow significantly over the coming year, with negative ramifications for growth, employment, and credit performance.”

From JP Morgan: “The main theme emerging from the BoJ’s September Tankan survey was the widening gap in business conditions between large firms, where conditions are steady, and smaller firms whose situation has deteriorated…The main theme emerging from the BoJ’s September Tankan survey was the widening gap in business conditions between large firms, where conditions are steady, and smaller firms whose situation has deteriorated…”

From Lehman: “The New York Times reported that collateralized debt obligations (CDOs) have begun to shut off payments to holders of low-rated tranches, following recent ratings downgrades of subprime mortgage backed securities. While the move was widely expected by market participants, the macro impact may only take effect with the realization of the losses.”

From Bloomberg: “The annual cost of attending a private four-year college in the U.S. rose 3.9 percent to $32,307 for this school year, the biggest inflation-adjusted increase since 2001… Colleges have raised prices more rapidly than inflation for 30 years… The total cost of attending a public four-year school for in-state students rose to an average of $13,589, a 3.8 percent increase after inflation, the biggest jump since 2004…”

From Bloomberg: “Commodities fell the most in two weeks, led by copper, oil, gold and corn, on concern that slowing economic growth will hurt demand for raw materials… The Group of Seven finance ministers and central bankers said the rising cost of credit will curb economic growth that had sent the cost of metals, grains and energy to record highs this year.”

End-of-Day Market Update

From RBSGC: “The bond market lost some ground Monday, led by the front end, as stocks and credit indices improved… Today's volumes were notably strong, particularly for a Monday…”

From Dow Jones: “The dollar slipped against the yen Monday as risk aversion increased due to a decline in global equity markets, spurring currency investors to unwind their yen carry trades. But the decline in risk appetite also created safe-haven buying of the greenback, allowing the dollar to rebound against the euro, even after the dollar hit a new all-time low versus the euro at the start of Asian session. Monday afternoon, the euro was at $1.4154 from $1.4292 late Friday[dollar index up .59 to 78.00, gold down $11 to $754]… Stocks pulled into positive territory Monday afternoon as selling after Friday’s steep drop abated, led by strength in technology stocks[Dow up 45 to 13567]… Crude oil futures fell under $87 Monday morning, pressured by reports that a Kurdish rebel group that has been attacking Turkish forces will call a ceasefire and by concerns over falling global equities.”[Oil settled down $1.04 at $87.56]

From Bloomberg: “Treasuries declined for the first time in six days as stocks rose and investor demand for the safety of U.S. debt waned with two-year note yields near the
lowest since September 2005. Two-year notes failed to extend the biggest gains last week since the Sept. 11, 2001, terrorist attacks as investors became more willing to take on the risk of corporate debt. Interest-rate swap spreads, a gauge of what companies pay over benchmark lending rates, narrowed the most in more than a week… The yield on two-year notes rose 7 basis points, or 0.07 percentage point, to 3.85 percent… The yield on the benchmark 10-year note gained 4 basis points to 4.43 percent… Two-year notes yield 91 basis points less that the Fed's target rate for overnight lending between banks. The gap reached 97 basis points on Oct. 19, the most since Sept. 17. The Fed on Sept. 18 cut its benchmark interest rate a half-percentage point to 4.75 percent. The two-year interest-rate swap spread narrowed 3 basis points to 68 basis points, the biggest drop since Oct. 11. The spread, an indication of risk aversion in the bond market, rose to as high as 79 basis points on Sept. 5 as investors demanded higher returns for holding corporate debt. Interest-rate futures traded on the Chicago Board of Trade show an 82 percent chance the Fed will lower borrowing costs a quarter-percentage point to 4.5 percent on Oct. 31. The odds were 32 percent on Oct. 15… The gap between the yield on asset-backed commercial paper and the fed funds rate shrank, signaling investors are less
concerned about the short-term debt. Issuers of one-day, asset-backed commercial paper are paying about 4.99 percent, or 24 basis points more than the Fed's funds rate, compared with a one-year average of about 21 basis points more, Bloomberg data show. Three-month bill yields rose for the first time in a week amid lower perceived risks of holding commercial paper. The yield rose 17 basis points to 3.99 percent… The difference between bill yields and the three-month London interbank offered rate, or Libor, shrank 22 basis points to 111 basis points. The difference averaged 39 basis points in the first seven months of the year before widening to 240 basis points on Aug. 20, the highest since the stock market crashed in 1987.”

From HSBC: “MBS pricing static as the world swirls. Pass thru pricing has been disabled for most of the day. MBS went from 4 wider to 2 tighter without moving a tic.”