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January 23, 2008 
TIDBITS

Record Rate Cut by Fed
From the Financial Times: “World markets are running out of superlatives. Tuesday saw the biggest cut by the Federal Reserve to its target Fed Funds rate in 26 years, and the biggest emergency cut it had ever made between scheduled meetings.”

From JP Morgan: “The Fed has not eased this much in a short period of time during the "modern" era of setting policy through fed funds rate changes. Indeed, the Greenspan Fed never eased by more than 50bp in one step. And the move by the Bernanke Fed over the past four months -- to a likely sub- 1% real funds rate next week (deflated by the core PCE), represents an unusually aggressive cumulative policy adjustment. During the past two cycles the funds rate reached this level only about six months after the economy had slid into recession… The Fed's action this week, signalling a likely 125bp move down in the funds rate over ten days, is unprecedented.” [Note that the author presumes the Fed will cut another 50bp at the FOMC meeting next week. This appears to be the consensus view.]

T-Bond Yields Touch Record Low

From Bloomberg: “U.S. Treasury notes gained, pushing two-year yields to the lowest since April 2004, on speculation the Federal Reserve will keep cutting interest rates to avert a recession in the world's largest economy. Benchmark 10-year yields dropped to the lowest since June 2003 as European stocks and futures on U.S. stock indexes
declined, prompting investors to seek safety in government debt. The Fed's decision yesterday to slash the target for overnight loans between banks to 3.5 percent pushed notes to the biggest rally since the aftermath of the Sept. 11, 2001, terrorist attacks… Benchmark 30-year yields touched 4.101 percent, the lowest since regular sales began in 1977… Two- year notes yielded 1.45 percentage points less than 10-year securities, close to the biggest gap since 2004. The steeper yield curve indicates investors favor shorter-maturity debt in anticipation of lower interest rates.”

Equity Markets Continue to Decline
From Bloomberg: “U.S. stocks dropped for a sixth day, the longest losing streak since April 2002…The Standard & Poor's 500 Index, which is off to its worst-ever start to a year… The Nasdaq Composite Index … is in a so-called bear market, marked by a more-than 20 percent drop from its almost seven-year high in October.”

Fed Rate Cut Helps Banks, But Risks Increasing Mal-Investment
From Citi: “It is also worth noting that, while the move has helped stabilise financial conditions (for now) and steepen the yield curve thereby helping the beleaguered banking sector, the underlying imbalances in the real economy remain and this may take a prolonged period of sub-trend growth to be addressed. Furthermore, the director of the US's CBO said yesterday that any planned fiscal stimulus would not have much impact on the US economy till the end of the year.”

From RBSGC: “So what do we think about the Fed's emergency intra-meeting 75bp rate cut? First and foremost, it's not a very encouraging sing when the Federal Reserve is forced to make such a move. Yes, it provides monetary stimulus, helps the earnings power of leveraged financial institutions and stops global equity markets from cratering (at least for the moment). But it also reeks of desperation, justifies investor fears about underlying economic conditions and validates criticism that the Fed has been late to provide help. However we certainly appreciate the positive impact of a sharp decline in market interest rates for credit worthy consumers and businesses. The drop in rates is consistent with our theme from last week: when all else fails, refi and inflate-away debt problems.”

From The Washington Post: “Looked at from a certain angle, the Fed's dramatic (though not unexpected) rate cut yesterday morning is a bit screwy. After all, what got us into this mess in the first place was too much cheap credit that was used to buy houses, finance corporate takeovers and commercial real estate and speculate in commodities, driving up the price of said houses, takeover targets, office buildings and commodities to levels unsupported by the economic fundamentals. Now the bubble has burst and the prices of those assets are beginning to fall back to more reasonable levels. Why would anyone want to interrupt that process by bringing back the cheap credit? The short and oversimplified answer can be summed up in three words: the Great Depression. For that was very much the attitude of the Federal Reserve and other central banks after the stock market crash of 1929. To a lesser extent, it is also the lesson of Japan’s's bungled policy response to the bursting of its real estate and stock market bubble in the early 1990s. As USA Today’s David J. Lynch pointed out in a timely piece yesterday, the leading academic expert on both failures is none other than the current chairman of the Federal Reserve, Ben S. Bernanke…At the moment, the Fed's big fear isn't a mild U.S. recession. It is a market meltdown in which the failure of one bank or hedge fund or insurance company triggers another and another as panicked investors and lenders all head for the exits at the same time. That's what the Fed and other central banks confronted last summer when they flooded markets with short-term credit to overcome the reluctance of banks to lend to one another. And it was what central bankers confronted again this week with the sharp sell-off on nearly all of the world's stock markets, where mounting concerns about a U.S. recession and banks failures and stock market bubbles in developing markets suddenly converged. Although Fed officials will claim in public that their three-quarter point rate cut was justified by risk to the economic fundamentals, simple logic tells you it ain't so. There's been nothing that has happened to the real economy in the past few weeks to justify an emergency meeting, let alone the biggest rate cut in more than two decades. Rather, the Fed's goal was to calm financial markets and take pressure off the balance sheets of troubled banks and insurance companies that benefit when borrowing costs are reduced…So is the Fed bailing out the big banks? Of course. It always does in these situations, even as it denies it… And it doesn't mean that the banks won't be required to come clean about their losses, even if shareholders wind up losing most of their money. But no matter how great the banks' folly, and no matter how much the Fed itself failed in its role as bank regulator during the bubble, the Fed will never allow them to collapse because the consequences to the financial system and the global economy would be too severe. Let's face it: When bubbles burst -- particularly ones as big and broad as this one -- there aren't any great outcomes or good policy options. There are only bad and less bad options. And so far, the Bernanke Fed -- drawing on the lessons of the Great Depression and Japan's "lost decade" -- seems to have chosen the less bad options. That's about all you can ask.”

From Bloomberg: “The Federal Reserve, which yesterday announced its first emergency rate cut since 2001, is ignoring history's lessons and risks re-igniting more asset bubbles, economists at the World Economic Forum annual meeting said… The central bank has drawn fire for paying too much attention to economic growth and not enough to asset prices, fueling unsustainable booms in stocks, property and derivatives… ``It's good for a central bank to ease when the risks are of a crash in the global economy, but that means you have to have a more systematic approach to asset bubbles,'' said Nouriel Roubini, founder of New York-based Roubini Global Economics LLC. ``If we have a `Greenspan put' or a `Bernanke put,' then we will create over and over again a distortion of excessive debt and leverage.''”

From CITI: “The Fed's surprise move yesterday has lowered USD Libors further but not by as much as the Fed's 75bp cut. While money markets had previously attained a degree of normality with the Libor-OIS spread fairly close to its pre-crisis levels, it remains to be seen if the Fed's aggressive easing will have the desired effect. The key to the dislocations in the financial markets still appear to still lie with the extent of balance sheet reconstruction by the major banks. The equity injections from SWFs have helped to shore up bank balance sheets but they may have to contract further, especially if weakness in the real economy starts to feed through.”

Still More Losses Expected from Banks and GSEs
From Deutsche Bank: “We think the market will continue to be subject to event shocks, particularly from bank/GSE earnings and the monoline situation. In addition, the sell-off in the dollar that is a result of the Fed ease will also likely put pressure on Asian economies and stock markets. Commodity prices in turn will be a function of the health of the global economy. One consistent theme of the recent bank earnings data is that there has been no more than modest efforts to reduce exposures to subprime, credit, or CMBS. Thus, Q4 2007 earnings do not seem to be the last of the bank losses, but rather could extend into 2008 if super senior CDO prices decline further. The immediate focus of the market is the monoline insurers, particularly their exposure to collateral calls from their CDS positions. Our impression is that counterparties will be loathe to make the mistake of others earlier in the crisis, when aggressive collateral calls worsened the crisis.”

From Citywire: “Senior executives at Fidelity Investments have identified three big risks for the banking sector from the problems being experienced by US monoline insurers. Firms such as Ambac, MBIA and ACA, which insure the credit worthiness of many of the structured bonds arranged by investment banks, are struggling to survive the credit crunch as downgrades by ratings agencies and slumping share prices call into question their business models…. fears of the potential impact this could have were a factor in yesterday's worldwide sell-off in markets as investors worried about the renewed threat of financial contagion arising from the sub-prime lending disaster… leading members of Fidelity's investment team said specific dangers to banks' balance sheets could quickly emerge if the bond insurers' cover is called into question, they said.
Investment banks could be forced to stand behind certain bonds if the credit ratings of these securities falls from the top AAA to AA. Structured investment vehicles (SIVs), which have already been badly hit by the sub-prime crisis, could suffer further losses from investments in monoline covered bonds and require greater support from banks.
Money market 'cash' funds run by banks could be forced sellers of vast quantities of monoline insured securities should they lose their AAA rating. This last factor is seen as particularly insidious as it would create a downward spiral in these assets, hurting insurers and other institutions which have also widely invested in them. This latest phase of the credit crunch increases the risk that what has so far been a financial crisis will spill over into the wider economy, sparking a recession.”

From Informa Global Markets: “Rumors galore are fueling the ferocious Treasury bid. Aside from the one reported about huge losses to come from a large French Bank, there is chatter that a German bank will have to write down E15bln, as well as one reporting a European bank of undetermined provenance losing credit lines with other banks.”

From Bloomberg: “New York State's insurance regulators met today with U.S. banks to discuss raising new capital for bond insurers, said a department spokesman. Talks in New York with the unnamed banks are part of Insurance Superintendent Eric Dinallo's effort to stabilize the bond guarantors and bolster the market's financial condition, said agency spokesman Andrew Mais in an interview. New capital may help preserve the top credit ratings for the bond guarantors such as MBIA Inc., the industry's largest, and halt any erosion of investor confidence in the $2 trillion of assets they guarantee. Ambac Financial Group Inc., MBIA's biggest rival, lost its AAA grade from Fitch Ratings this month on concern about rising defaults tied to subprime mortgages.”

Health of Mortgage Insurers Raises Concern Over Fannie Mae’s Business
The Street.com: “The private mortgage insurance industry is under severe pressure from rising delinquencies and mounting losses. Now questions are swirling about how a potential blow-up in that sector will affect Fannie Mae. As the largest purchaser of U.S. mortgages, Fannie Mae provides an essential backstop to the housing market. The government-sponsored entity…purchases mostly standard 80% loan-to-value mortgages -- those for which the homebuyer puts down 20% equity. Due to a quirk in its charter, Fannie Mae is allowed to purchase mortgages with loan-to-value, or LTV, ratios greater than 80% -- and as high as 100%. Generally, these are allowed only if the homeowner purchases mortgage insurance to cover the amount of the loan above 80%. This business model works fine as long as Fannie Mae believes it can be reimbursed from the private mortgage insurers. But as housing prices fall, borrowers are defaulting at a faster pace on high-LTV mortgages. In turn, private mortgage insurers -- who cover these risky loans -- have had their stocks crushed…as investors worry about whether the companies can fund their payments to lenders as mortgage defaults rise. There are a few looming questions regarding Fannie Mae's exposure to the private mortgage insurers. One is whether Fannie Mae has adequately reserved for possible losses, because the company operates with the understanding that the insurers will pay it back. The other issue is that if one of these insurers takes a massive hit, then Fannie Mae's underwriting standards may come under scrutiny, and the firm may be forced into buying fewer high-LTV mortgages in the future…Fannie Mae has $227 billion of exposure to mortgage loans in which the LTV ratios are greater than 90%. Overall, about 19% of the company's $2.4 trillion single-family mortgage book of business has private mortgage insurance or some other form of credit enhancement. Troubles among bond insurers may provide a clue about how Fannie Mae would be forced to act if mortgage insurers' troubles grow…In its most recent quarterly filing, Fannie Mae said it had $130.3 billion of recoveries from private mortgage insurance policies and other credit enhancements. However, if the firm decides that portions of its mortgage insurance are useless, then increased default reserves -- and thus larger writedowns -- may be looming. Fannie Mae has just $39.9 billion of shareholder equity to absorb these losses. So far, Wall Street sell-side analysts have not expressed much concern about the issue. In a November 2007 research note, Lehman Brothers analyst Bruce Harting said Fannie Mae and Freddie Mac were "reasonably well insulated vis-à-vis the mortgage insurance industry in total."…"It looks to us like a lot of the mortgage issuers will not survive if any kind of really bleak outcome comes to pass," Narayanan told Fannie officials on the firm's last earnings call in November. "To the extent that some of their risks may not be insurable by them if they're not in existence, it comes back on your books," he said. "So there's clearly a much more complicated interlinked relationship you have with a number of other providers, which are all possibly at risk in this situation." In response, Fannie Mae's chief risk officer Enrico Dallavecchia said the company believes that the mortgage insurance industry "will manage its capital position to meet the claims obligations that they have." "I feel comfortable with the exposure that we have to the MI (mortgage insurance industry) at this stage," Dallavecchia said. While the write-offs of existing mortgage insurance could be looming for Fannie Mae, another worry is that these increased losses will cause Fannie to curtail use of the insurance product in the future. Fannie Mae continues to use mortgage insurance to buy loans at a maximum LTV of 95% these days, mortgage brokers say. "What happens if Fannie realizes that mortgage insurance guarantees are worthless and decided not to take mortgage insurance-wrapped mortgages anymore?" says an analyst at a hedge fund that is shorting Fannie Mae and several mortgage insurance firms. "The whole mortgage world will be turned upside down," the analyst says. "This is the real problem."”

From Bloomberg: “Fannie Mae and Freddie Mac, the two largest sources of money for U.S. home loans, may need to recognize $16 billion in losses in fourth-quarter earnings and capital levels because of declines in the value of subprime- mortgage bonds, according to Credit Suisse Group… With other financial companies this quarter already reporting ``other than temporary impairments'' of mortgage- related holdings that they wouldn't normally need to report under accounting rules, Fannie Mae and Freddie Mac may need to follow suit, the analysts wrote in a report today. ``We believe that this will likely spur the GSEs' regulator to compel similar actions,'' they wrote, referring to the Office of Federal Housing Enterprise Oversight, regulator to the so- called government-sponsored enterprises. McLean, Virginia-based Freddie Mac's subprime securities may be worth $8 billion to $11 billion less than the prices at which the company is carrying them on its books, while Washington-based Fannie Mae's bonds may be worth $2.25 billion to $5 billion less, according to Credit Suisse. Without ``other than temporary'' impairments, or declines in the value of the securities unlikely to be recovered, the losses don't affect the companies' earnings or capital, the analysts wrote. The losses would affect the book values, or their assets minus liabilities, the companies reported, they wrote. Through September of last year, the companies had only reported 1.5 percent declines in their value of their subprime securities, through adjustments to their book values, they wrote.
The potential losses don't reflect the companies' holdings of securities backed by Alt A mortgages, or loans considered between subprime and prime in terms of default risks, the analysts wrote. Non-agency mortgage securities are ones not guaranteed by the two companies or federal agency Ginnie Mae.”

Good Profits in Municipal Bond Insurance Before Diversifying into MI
From Bloomberg: “Municipal bond insurers such as MBIA Inc. and Ambac Financial Group Inc. had a good thing going. For years, they earned some of the highest profit margins in any industry -- by writing coverage for securities sold by states and cities to build roads, schools and firehouses. During the past five years, MBIA's average profit margin was 39 percent, more than four times the average of the Standard & Poor's 500 Index, according to data compiled by Bloomberg. Ambac's average profit margin was 48 percent. The good times are over, and the culprit isn't municipal bonds; it's subprime debt, a market the insurers waded into in pursuit of even greater profits. Some of the biggest bond insurers are facing potential claims that may deplete their capital. Their share prices have plunged, and credit rating companies are scrutinizing their AAA status. Ambac became the first insurer to lose its triple-A rating, when Fitch Ratings downgraded the company to AA on Jan. 18… ACA founder Fraser says the bond insurance industry needs to do more than raise capital: It needs to restore faith in its unquestioned ability to assess credit risk… By chasing the higher profits of CDOs while underestimating the risks, the bond insurers jeopardized their basic business: insuring municipalities against default. In practice, cities and states rarely default. That's because they can raise taxes to meet obligations or refinance their debts. The designers of CDOs don't have those options.”

Increased Debt Helped Fuel Boom & Will Likely Retard Recovery as Its Paid Back
From NATIXIS: “…US Non-Federal Debt per capita, as a multiple of real output per capita (the “per capitas” cancel, but it is helpful to think about the debt in terms of how much more an average person owes than he produces in a year). In the middle of the “Me Decade” of the 1980s, debt was some 65% higher than output; today, it is 120% higher. To be sure, the numerator is a stock figure and the denominator is a flow figure, but so is a person’s debt compared to their income. If the average person owes more than twice what he makes in a year, where does the money come “from the sidelines” this time? All of the money is in the market now; some of it is also trapped in housing where the tightening of credit conditions and the decline in the value of the housing stock has made it difficult to extract. No one has saved for a rainy day.”

From The New York Times: “The recent financial turmoil has many causes, but they are tied to a basic fear that some of the economic successes of the last generation may yet turn out to be a mirage…The great moderation now seems to have depended — in part — on a huge speculative bubble, first in stocks and then real estate, that hid the economy’s rough edges. Everyone from first-time home buyers to Wall Street chief executives made bets they did not fully understand, and then spent money as if those bets couldn’t go bad. For the past 16 years, American consumers have increased their overall spending every single quarter, which is almost twice as long as any previous streak. Now, some worry, comes the payback. Martin Feldstein, the éminence grise of Republican economists, says he is concerned that the economy “could slip into a recession and that the recession could be a long, deep, severe one.”…[Bank] are facing real losses, which will almost certainly curtail lending, and economic growth, this year. The second problem is that real estate and stocks remain fairly expensive. This shows just how big the bubbles were: despite the recent declines, stock prices and home values have still not returned to historical norms. David Rosenberg, a Merrill Lynch economist, says that the stock market is overvalued by 10 percent relative to corporate earnings and interest rates. And remember that stocks usually fall more than they should during a bear market, much as they rise more than they should during a bull market. The situation with house prices looks worse. Until 2000, the relationship between house prices and rents remained fairly steady. The same could be said about house prices relative to household incomes and mortgage rates. But the boom of the last decade changed this entirely. For prices to return to the old norm, they would still need to fall 30 percent across much of Florida, California and the Southwest and about 20 percent in the Northeast. This could happen quickly, or prices could remain stagnant for years while incomes and rents caught up. Cheaper stocks and houses will benefit many people — namely those who don’t yet own a home and still have most of their 401(k) investing in front of them. But the price declines will also lead directly to the third big economic problem. Consumer spending kept on rising for the last 16 years largely because families tapped into their newfound wealth, often taking out loans to supplement their income. This increase in debt — as a recent study co-written by the vice chairman of the Fed dryly put it — “is not likely to be repeated.” So just as rising asset values cushioned the last two downturns, falling values could aggravate the next one. “What people have done is make an assumption that these prices could continue rising at the rate they had been,” said Ed McKelvey, an economist at Goldman Sachs. “And that does seem to have been an unreasonable assumption.””

From Minneapolis Star Tribune: “Many U.S. consumers are tapped out -- over-mortgaged and over-borrowed with no savings to fall back on. The homes that helped finance their spending sprees are now falling in value, and higher food and energy costs are digging deeper into their wallets daily. Increasingly, they're falling behind on mortgage and car payments as well as credit card bills. But there's something more, and it's new, said Jerrold Peterson, economics professor emeritus at the University of Minnesota at Duluth. It's fear. "For every one mortgage foreclosure there are four of us saying, 'There but for the grace of God go I,'" Peterson said. "As I see houses repossessed, and home values go down and down, am I really going to want to buy an automobile, or even a whole lot of new clothes?"… The interest rate drop could encourage spending because the rates of many consumer loans are tied to it, including most credit cards. The president's hope is that Americans will go out and spend any rebate check that comes their way. Both strategies have worked before, some economists said… "All of a rebate won't go to spending," … "There will be some, but others will put it in savings for a rainy day, or pay down bills they otherwise couldn't have." Indeed, more Americans -- some 34 percent -- intend to cut their spending, according to a national survey reported last week on Cardtrak.com, which tracks the credit card industry. That's up from 21 percent six months ago. Also, 57 percent said they will try to reduce their debt and save more money. That could be out of necessity. Delinquency rates for the major credit cards stood at 5.01 percent in December, up from 4.44 percent a year earlier…At the same time, average balances neared $10,000 last year, up nearly $400 in a year. Even Target Corp. has seen the problems. The Minneapolis-based discount retailer wrote off 6.84 percent of its charge receivables in December, a 20 percent increase since August.”

In a Recession, Merrill Lynch Sees Further Large Drops for Housing and Stocks
From Merrill Lynch: “We have concluded that the supply-demand backdrop in the residential real market is still so far out of equilibrium that average home prices nationwide have the potential to drop a further 25-30% over the next two to three years. This sounds dire (and it is - effectively wiping out three years of price appreciation) but would only reverse part of the unprecedented 130% price surge from 2000 to 2006…If in fact the economy is in a recession or on the precipice thereof, then the historical record shows that these setbacks in the real economy usher in an average 25% decline in the S&P 500. Because it is normal to have 70% of the prior bull market reversed in the cyclical bear market, such a re-occurrence this time around would imply a breach of 1,100 on the S&P 500 or a further 20-25% downside from here. Remember - these are just averages. So we have a situation where both house values and equity prices, having already fallen decisively from their peaks, have the potential to drop another 25% from here. And that is what we have built into our new assumptions for the GDP forecast, keeping in mind that both asset classes combined exceed $40 trillion on the household balance sheet and represent almost 70% of aggregate household net worth.”

Possible Impacts on Society from the End of Cheap Oil
From Bloomberg: “`This is what the end of the age of oil means,'' says Reinert, 60, who plans the vehicles Toyota will make in a quarter century as national manager for advanced technology at the U.S. sales unit in Torrance, California. ``The car-based culture, the business-as-usual of building cars and trucks, is going to change dramatically.'' … Today, the twin threats of $100-a-barrel oil and global warming are convulsing an industry addicted to cheap, abundant petroleum. Auto companies, already hurt in 2007 by the lowest U.S. demand in a decade, are struggling to perfect cars that run
on ethanol, diesel, natural gas, hydrogen and household electricity… Reinert says automakers are endangering themselves by basing sales and profits on the big, fast cars that many U.S. customers say they want in 2008. In five years, as oil shortages and global warming intensify, car companies may be out of step with drivers' demands for fuel-efficient vehicles. Even worse, degrading stretches of the planet like Fort McMurray will only delay -- not prevent -- the time when the world must function in a post-peak- petroleum economy… Shareholder ambivalence about clean cars is only one hurdle
to surviving the end of easy oil… There's no blueprint for the impact of increasingly scarce oil on a U.S. economy already laboring with a mortgage crisis and a dropping dollar. Add industrialization in China and India, and the number of cars and trucks worldwide may double to 2.1 billion by 2030, according to the Paris-based International Energy Agency. ``We don't have a past, a history or a database that allows us to explore the simultaneous impact of recessions, disruptions to the energy supply and climate change,'' says Reinert… Reinert defends Toyota's need for sport utility vehicles, minivans and pickups, which contributed 42 percent of its 2.6 million U.S. vehicle sales in 2007. The company earns about $6,000 before taxes in the U.S. on an SUV. That compares with a $1,000 profit on a Corolla and a small loss on a Prius… ``Without these profits, where does the investment capital come from for our research on plug-ins or fuel cells?'' Reinert asks… at Fort McMurray's pit mines, it takes 2 tons of sand, 250 gallons (947 liters) of water and 1,400 cubic feet (39.6 cubic meters) of natural gas to produce one barrel of synthetic crude…That's enough water for a day's use for a U.S. family of four and enough natural gas for 5.6 days. The gas is burned to power a process that extracts a tarry substance called bitumen from the sand and then refines it into synthetic crude….``When you're schlepping around two tons of sand for a barrel of crude, it shows that conventional oil is already well into depletion,'' says Jeffrey Rubin, chief economist at CIBC World Markets Inc. in Toronto. ``Price will ultimately ration demand. People won't be able to afford to drive.''… ``It's definitely true that the era of cheap and easy oil is over,'' says Brad Bellows, spokesman for Suncor Energy Inc., which opened Fort McMurray's first commercial oil sands mine in 1967. ``Industry is looking offshore and to unconventional sources like oil sands.'' Oil sands facility operators are working to minimize environmental harm by recycling water faster and using the refining process to produce heat that's now generated with gas, Stringham and Bellows say. They're also trying to sequester carbon dioxide emissions underground and quickly restore land to its original condition. Wells predicts world oil production will peak at about 100 million barrels a day in about a decade. By 2030, output will fall to today's level of 87 million barrels. Declining production will collide with rising demand, which could hit 118 million barrels a day by 2030 if trends were to continue, the U.S. Energy Information Administration forecasts. ``When production levels off, if the price is $200 or $300 a barrel, then that's what people will pay.'' Wells says. Reinert says that although oil may drop in price because of a global recession, it's likely to gyrate between $75 and $125 a barrel for the next five years… Cities must be redesigned too. People need to rely on mass transit and live closer to where they work. ``In a place like New York, there may not be a role for our traditional product -- I don't mean today but 20 or 30 years from now,''… Since 1950, the world has been blessed with an eightfold increase in oil production. Yet the peak discoveries for new oil came in 1962, petroleum consultant Wells says. Total production outside the former Soviet Union and the Organization of Petroleum Exporting Countries topped out two years ago, he says. Oil in the former Soviet Union will reach its highest level in about five years; OPEC will peak in about 10, he says. In the interim, nations will be more dependent on the Middle East, where getting oil is complicated by war, political turmoil and declining output from mature wells. ``After a series of incidents in the Persian Gulf, or a low-level nuclear exchange that shuts off oil supplies, you wouldn't have a short-term disruption like Katrina,'' Reinert
says. ``You would have a profound one- or two- or three-year period in which economies and governments fail.''

Return Assumptions for Pension Plans May Need to be Lowered
From NATIXIS: “Here’s something else to put on the worry list; it is something we haven’t worried about in a while. For some time now, bullish analysts have talked about the great condition of corporate balance sheets. For years, they have been ignoring the off-balance-sheet pension and OPEB liabilities, but in recent years the aggregate pension deficit had healed somewhat given the enormous rally in equities and the selloff in the bond market between 2003 and 2007. As a quick review, higher interest rates lower the pension liability by raising the discount rate, while higher equity prices increase the pension asset since most pensions are laden with far more equities than is prudent. But now, those pension gains have been significantly eroded. While equities are still dramatically above their 2003 lows, the pension surplus is considerably more sensitive to interest rates and the big rally we have had over the last six months will put a large liability on the pristine corporate balance sheets. And in fact, this will actually begin to show up on corporate balance sheets, and not just in the footnotes, due to FASB rules passed last year. This will become a big story unless bonds sell off appreciably and equities rally back. This would seem to be a good time to congratulate the folks at Ford, who on July 26th announced plans to change their pension allocation from 70%-30% (equities-fixed income) to 55%-45%. They probably saved their shareholders and/or pensioners billions of dollars with that move. The bad news about this about-face in the fortunes of corporate pension and OPEB plans is that it will make it more difficult for the pension fund managers to do what they should be doing, and that is to sell equities and buy long Treasuries or (in the case especially of an OPEB plan) TIPS. At this level of
real yields, it would be hard to stomach such a program in any event, but it will be even harder to buy TIPS at 1.40% real yields when you had a chance at 2.80% back in June (note that we argued strongly for buying them at that point). But what assets can a pension fund hold instead? Real estate? Gold, with no yield? Equities? However you slice it, one casualty of the recent market move is likely to be a change in the implausibly-high return assumptions used to calculate the pension plan’s funded status. At a 1.4% real yield, a 7% or 8% blended nominal return for a portfolio requires a willful act of disbelief. Without sharply higher inflation (and such does not appear to be on the horizon), nominal
returns averaging 5% over the next 10 years will be difficult to come by.” [Note – One bright spot may be that overseas equities have seen higher returns, so diversifying into foreign/emerging market stock markets may help improve total returns for retirement funds.]

MISC
From RBSGC: “The investment grade credit market has also seen financing rates drop, but it has not been as dramatic as the fall in mortgage rates. High Yield has seen an even tougher time, with yields in that sector crossing above 10.00% for the first time since 2003. The profits picture has soured, fears of defaults have grown, and pricing now reflects plenty of anxiety.”

From Citi: “Fed Funds/U.S. 2 year yield spread: Yesterday’s actions fail to put the fire out. Prior to yesterday’s Fed Funds cut this spread had moved to 226 bps Fed Funds over U.S. 2 year yields. This was a 2-decade plus extreme. While immediately afterwards the spread did narrow sharply with today’s move it is back to 165 basis points. By historic standards this is again back into extreme territory. This reminds us that while yesterday’s move is a step in the right direction, it currently appears significantly more is needed to quell market fears.”

From AP: “An economic activity index calculated by the Federal Reserve Bank of Chicago showed its lowest level in more than four years in December, dragged down by a sharp contraction in employment-related indicators, the bank said Tuesday…The three-month average, which the Chicago Fed says provides a more consistent picture of national economic growth than the volatile monthly readings, hit its lowest level since May 2003…The three-month average was below zero for every month in 2007, indicating below-average economic growth throughout the year. The data are in line with other recent indicators of economic weakness that have caused financial markets to swoon and led to several interest rate cuts by the Federal Reserve. In December, each of the four broad categories in the Chicago Fed Index were negative…”

From The Financial Times: “…the Baltic Dry index, which measures demand for shipping, has fallen more than 40 per cent since peaking late last year…”

From Morgan Stanley: “As a group, we think the US economy is in recession, that Europe is most vulnerable to spillovers from that downturn, but that many emerging market economies are much less exposed. Decoupling means simply that a US recession won't likely cripple EM as in the past. A US recession will help cool an overheated Chinese economy.”

From the Financial Times: “The mood of chief executives has darkened for the first time since 2003, according to a survey of corporate leaders released on the eve of the World Economic Forum. Fears of a recession have displaced concerns such as terrorism and regulation. The fall in business confidence was most pronounced in the US, where only 35 per cent of CEOs said they were “very confident” about growth – down from 53 per cent a year ago. The survey of 1,150 senior executives by PricewaterhouseCoopers was conducted late last year – before the latest fall in global markets.”

From AFP: “China on Wednesday issued an "urgent" call for the coal industry, electricity providers and government agencies to ensure adequate coal supplies as a nationwide power crisis loomed… The looming supply shortage had already caused 13 provincial power grids in central and southern China to impose restrictions on electricity use, it added. The report said the booming nation's stockpile of coal, which provides about 70 percent of China's power needs, had dwindled to a mere week's supply in recent days… China's electricity consumption has soared amid booming economic growth, putting the government in a quandary about how to meet that demand while simultaneously limiting consumption of heavily polluting coal and cutting down on the chronic deadly accidents in the coal mining industry. The situation has been worsened by several other factors including drought conditions that have hit hydroelectric output, the commission said.”

From Bloomberg: “European Central Bank President Jean- Claude Trichet said he's committed to fighting inflation, attempting to quash speculation he'll follow the U.S. Federal Reserve in cutting interest rates after stocks plunged. ``Particularly in demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility,'' Trichet told the European Parliament in Brussels today. Bond investors dismissed his comments and raised bets on an ECB interest-rate cut. European two-year government notes rose the most since September 2001…”

End-of-Day Market Update
Five Day Chart of S&P 500 Showing Early New Low before the Afternoon Rally
Five Day Chart of 10-Year Treasury Yields (27bp high-low range today)

From Citi: “Yields moved 15 bps instantly on the news that NY state regulators meeting with banks to rescue bond insurers… the speed of the turn and reverse certainly tells you
that the short-term last-to-the-party bulls out there don't have deep pockets and are certainly nervous about owning bonds at these nose-bleed yield levels. It also tells you that a lot of the selling in equities of late is of similar fast-money type. Anyway, while I never believe that civil servants are going the save the day for the financial markets, this could have enough momentum to it to continue the correction for a couple of days. Oh, and if you think trading duration is tough on a day like today, how about Swap Spreads? Where they typically bounce around in a 1 or 2bp range (and even less pre-meltdown) … we've seen a NINE bps swing from low to high in 30yr spreads today. Impressive.”

From CNN: “Blue chips rallied Wednesday afternoon, with the Dow bouncing back from a more than 300-point loss earlier in the session, while the Nasdaq erased losses sparked by Apple's profit warning. The Dow Jones industrial added almost 300 points, after having fallen more than 300 points earlier in the session. The Standard & Poor's 500 index rose 2.1 percent. The Nasdaq composite gained 1 percent after sinking more than 3 percent earlier in the session.”
Three month T-Bill yield fell 13 bp to 2.19%.
Two year T-Note yield rose 11 bp to 2.11%
Ten year T-Note yield rose 13 bp to 3.56%
Dow rose 299 to 12,270
S&P 500 rose 28 to 1339
Dollar index steady at 76.32
Yen at 106.67 per dollar
Euro at 1.464
Gold down $2 at $890
Oil fell $1.50 to $87.72
*All prices as of 4:20pm