Today's Tidbits

Recently Retired Top Fed Economist Expects 50bp from FOMC
From MarketWatch: “The Federal Open Market Committee is likely to cut rates again by a half-point on Wednesday, according to former top Fed staffer Vincent Reinhart. Fed watchers pay attention to Reinhart because he has the distinction of being the last man who has come in from the cold, having left the Fed's marble temple last year for the private sector. Reinhart worked at the Fed for twenty-five years, rising to become the top staffer on monetary policy. In an interview with MarketWatch, Reinhart said the Bernanke Fed "clearly has to ease" on Wednesday. A half-point cut is the "most likely" action, but a quarter-point cut shouldn't be ruled out, he said. Fed officials would like nothing better than to hold rates steady and show independence from the market, but this is not the time for such action, Reinhart said, as financial markets are so volatile and skittish. "They are not in a situation where they can disappoint market participants," Reinhart said in an interview at the American Enterprise Institute, the conservative think-tank he has joined as a research scholar. Traders are pricing in about an 86% chance of a half-point rate cut on Wednesday.”

Loan Limit Changes
From American Banker: “A deal to include Federal Housing Administration reform and let Fannie Mae and Freddie Mac have a slice of the jumbo loan market in the economic stimulus package was on the rocks Monday, according to sources. A Hill aide said House lawmakers - under pressure from Treasury Secretary Henry Paulson - were poised to scrap FHA reform from the stimulus package. A Treasury spokeswoman said Mr. Paulson wants Congress to handle FHA reform separately to avoid slowing down the legislation, which is intended to provide a quick boost to the economy. "Treasury continues to support FHA modernization and believes it should be completed as soon as possible on a separate track from the stimulus package," the spokeswoman said. Another provision of the bill, which would temporarily raise the conforming loan limit, was also in jeopardy, sources said. House Financial Services Committee Chairman Barney Frank first announced last week a deal with the White House that included a one-year increase in the loan limits of Fannie and Freddie to 125% of the local median house cost, with a cap of $729,750. But one source said the White House and House were still debating the scope of a conforming loan limit increase. The White House would like to limit the increase only to new loans, while House leadership would like it to also apply to existing mortgages. It was unclear if policymakers can work out their differences before the House is expected to vote on the stimulus plan Tuesday. Mr. Paulson made no secret last week that he was not pleased lawmakers had included a temporary conforming loan limit increase in the stimulus bill. The conventional wisdom in Washington is that raising the conforming loan limit saps momentum for a broader GSE regulatory reform package. Mr. Paulson said last week he was run down by a "bipartisan steamroller" over the issue, but said he ultimately supported the stimulus package. Removal of the FHA reform package from the stimulus bill, however, is more of a surprise. President Bush has personally urged Congress several times to pass the bill, which would allow the FHA to insure more loans. Lawmakers, however, were still trying to hammer out differences last week between the House and Senate versions of reform. The Senate bill would reduce FHA downpayment requirements to 1.5%, while the House bill would allow the program to insure loans with no downpayment.”

From RBSGC: “By our estimates, 67% of the $2.5 trillion Jumbo market would be refinancible at a loan size limit of $625 K. The impact on the Alt-A sector would be minimal. The SIFMA call this afternoon provided little clarity regarding the TBA eligibility of these loans.”

From Deutsche Bank: “We estimate between $250-$300 bn in additional agency MBS supply due to the higher conforming loan limit.”

Increased Eligibility for FHA Mortgages
From LEHC: “While most of the stories written about loan limits and last week’s economic stimulus package have focused on the “conforming” loan limit that applies to loans purchased or securitized by Fannie and Freddie, the real “eye-popper” is the proposal to increase permanently the FHA loan limit – either to as much as $729,250 depending on local housing costs, or to $625,000. FHA financing has traditionally been focused on “low-to-moderate income” lending, and FHA insurance is a government guarantee. The maximum front-end (mortgage payment) and back-end (all debt payments) debt-to-income underwriting ratios for FHA-insured loans approved via manual underwriting are 31% and 43%, respectively. Ratios can be higher if loans go through an automated underwriting engine and there are “compensating factors”, but 31%/43% are the standards. Those ratios focus on total payments including escrow for taxes and insurance (and any condo/HOA fees), and full documentation of income and assets is required. If one just focuses on the front-end ratio, let’s consider a borrower that has a 30-year fixed-rate FHA mortgage with a 6% rate (included the MI premium), and that annual T&I/other expenses are a (conservative) 1.5% of the value of the home. Let’s assume that the borrower puts down just 3% (though at least one version of the FHA modernization act would put the minimum down payment down to 1.5% -- a scary proposal given that home prices are declining in so many parts of the country). And, to be conservative, let’s assume that no MI/other closing costs are financed. For someone taking out a $625,000 FHA-insured mortgage to buy a home “priced” at $644,330, the income needed to have a front end ratio of 31% would be $176,229.80! And for someone taking out a $729,750 FHA-insured mortgage to buy a home “priced” at $752,320, the income needed to have a front-end ratio of 31% would be $205,765.91!!!!! About 95% of US households have incomes below $176,230, and about 95% of California households have incomes below $205,766!!!! So these new loan limits would “open up” government-insured mortgage financing to folks with a high debt-to-income ratio and low down payment to almost everyone, including households with incomes about 3.6 times the US median, and 2.7 times the US average!!!! According to the FY 2007 MMI Fund Analysis Actuarial Review, the FHA share of the mortgage-financed home purchase market declined from around 18% in 1990 to around 4% in 2006 and 2007 (fiscal, not calendar year).”
Value-At-Risk No Longer Considered Sufficient Risk Metric

From Bloomberg: “The risk-taking model that emboldened Wall Street to trade with impunity is broken and everyone from Merrill Lynch & Co. Chief Executive Officer John Thain to Morgan Stanley Chief Financial Officer Colm Kelleher is coming to the realization that no algorithm or triple-A rating can substitute for old-fashioned due diligence. Value at risk, the measure banks use to calculate the maximum their trades can lose each day, failed to detect the scope of the U.S. subprime mortgage market's …The past six months have exposed the flaws of a financial measure based on historical prices that securities firms use idiosyncratically and that doesn't anticipate every potential disaster, such as the mistaken credit ratings on defaulted subprime debt. ``Finance is an area that's dominated by rare events,'' said Nassim Taleb, a research professor at London Business School and former options trader. ``The tools we have in quantitative finance do not work in what I call the `Black Swan' domain.'' Taleb's book ``The Black Swan”… describes how people underestimate the impact of infrequent occurrences. Just as it was assumed that all swans were white until the first black species was spotted in Australia during the 17th century, historical analysis is an inadequate way to judge risk, he said. Executives at Merrill, Morgan Stanley and UBS took steps in the past six weeks to overhaul their risk-management groups after internal models failed to foresee the first annual decline in house prices since the Great Depression that eroded five years of trading gains… Thain, who replaced the ousted Stan O'Neal last month at Merrill, said Jan. 17 that the largest U.S. brokerage should stop making trades that have the potential to wipe out profits…UBS CEO Marcel Rohner told employees two weeks ago that Europe's biggest bank will scale back risk taking after reporting a $15 billion writedown last year for subprime- infected investments…At New York-based Morgan Stanley, which disclosed a $3.56 billion fourth-quarter loss after writing down mortgage-related and other securities by $9.4 billion, the risk department will now report directly to Kelleher instead of to the trading heads. The firm said it plans to hire more risk managers… Hiring risk managers and giving them more power won't alter the mistake that led to last year's slump and that was Wall Street's dependence on statistics to quantify risks, Taleb said. ``We have had dismal failures in quantitative finance in measuring these risks, yet people hire quants and hire risk managers simply to back up their desire to take these risks,'' he said. ``There are some probabilities that you cannot compute.''… All the New York-based firms base their calculations at a confidence level of 95 percent, meaning they don't expect one- day drops to exceed the reported amount more than 5 percent of the time. The amounts differ in part because every firm uses their own methodology and data. For instance, Lehman uses four years of historical data to calculate VaR, with a higher weighting given to more recent time periods, while Morgan Stanley provides VaR calculations using both four years and one year of market data. ``If you compare what peoples' values at risk are versus what their losses were in the third quarter or fourth quarter, the numbers are astounding,'' said David Einhorn, president and co-founder of hedge fund Greenlight Capital LLC in New York. ``There are a lot of things that probably the value-at-risk model said would have trivial losses 95 percent of the time or 99 percent of the time but are now having a huge loss.'' Merrill's highest one-day value at risk in the third quarter was $92 million, indicating that the firm's maximum expected cost during the 63-trading day period would be $5.8 billion. In fact, the firm wrote down $8.4 billion from the value of collateralized debt obligations, subprime mortgages and leveraged finance commitments, 45 percent more than the worst- case scenario. All of the risk-measurement tools failed to prepare Merrill for the unforeseen declines on triple-A rated securities backed by subprime mortgages, according to the company's third-quarter filing with the U.S. Securities and Exchange Commission. The firm's writedowns related to the highest-rated portions of CDOs backed by pools of home loans, which plunged in value as defaults on the underlying mortgages soared. ``VaR, stress tests and other risk measures significantly underestimated the magnitude of actual loss from the unprecedented credit market environment,'' Merrill's filing said. ``In the past, these AAA ABS CDO securities had never experienced a significant loss in value.'' Securities firms developed statistical models during the early 1990s to better quantify risks as the trading of bonds, stocks, currencies and derivatives increased. J.P. Morgan & Co., now part of JPMorgan Chase & Co., helped popularize the use of value at risk as the primary measurement tool in 1994 when it published its so-called RiskMetrics system. Four years later, two events helped demonstrate the drawbacks in using statistical analysis based on historical market movements to measure risk. Russia's bond default sent fixed-income markets into a tailspin and Long-Term Capital Management LP, the Greenwich, Connecticut-based hedge fund run by former Salomon Brothers trader John W. Meriwether, had to be bailed out after $4 billion of trading declines. Russia's default risk was underestimated because value-at- risk computations used by investment banks depended on market events of the preceding two to three years, when nothing similar had occurred…Long-Term Capital Management, which amplified its risk by relying on borrowed money for most of its trading bets, blew up in part because it didn't anticipate that investor panic after the Russian default would cut the value of any risky debt, whether it was issued by a country, sold by a company, or backed by mortgages…``In a market stress event, some individual sectors that previously appeared unrelated do move together, and as a result, the organization could take losses on both of them or even on positions that were previously deemed to be a hedge,…The other risk tool commonly used by securities firms, known as stress testing or scenario analysis, also failed to prepare the industry for the plummeting value of AAA-rated securities that had previously been deemed the most creditworthy…``Stress tests are only as good or as predictive as the scenarios used and in many cases the scenarios that played out were much more severe than people anticipated,'' … ``One lesson learned is that these stress tests should be broader, should consider more scenarios.'' … VaR provides a service if used every day because it can pick up fluctuations in the risk that the firm is taking in some distant region or an arcane product that might not otherwise be noticed. Investment banks will continue to take unsafe risks as long as traders are rewarded for making profits, leaving shareholders, bondholders and sometimes taxpayers to shoulder the consequences, Taleb said.”

Japan’s Economy Slowing
From Bloomberg: “Japan's economy is particularly at risk. Its housing market is slumping as stricter building-permit rules drag home starts to a four-decade low. A drop in construction demand led Tokyo Steel Manufacturing Co., the nation's biggest maker of steel girders, to lower its profit forecast Jan. 22. It's ``highly likely'' Japan is already in a recession or will enter one this quarter, Tetsufumi Yamakawa, chief Japan economist at Goldman in Tokyo, wrote in a report published today. The yen's 13 percent rise versus the dollar in the last six months is also taking a toll. The Japanese currency reached a 2 1/2-year high of 104.97 to the dollar last week. That is near the break-even point for Japan's exporters, who say they can remain profitable as long as the currency is weaker than 106.6, according to a government survey. Kozo Yamamoto, head of the ruling Liberal Democratic Party's monetary policy panel, urged the Bank of Japan to cut its benchmark interest rate, already the lowest in the industrialized world at 0.5 percent. ``Concerns over a recession are emerging not only in the U.S., but in Japan as well,'' Yamamoto said in a Jan. 23 interview. ``The BOJ should cut rates back to zero immediately.''”

Study Indicates Credit Derivatives Increase Company Bankruptcy
From The Financial Times: “A boom in the use of derivatives is giving creditors strong incentives to push troubled companies into bankruptcy rather than help rescue them, according to new research and industry experts. A study by academics Henry Hu and Bernard Black concludes that, thanks to explosive growth in credit derivatives, debt-holders such as banks and hedge funds have often more to gain if companies fail than if they survive. The study suggests this development could endanger the stability of the financial system. The findings highlight a crucial problem in corporate restructuring when more and more companies are facing financial difficulties as a result of the credit crunch and US economic slowdown. According to the research and industry practitioners, creditors have a strong interest in voting against a restructuring plan if they have bought credit or loan default swaps, which trigger payments when a company fails…. “[investor’s] financial interests may be best served by forcing a default if they are on the right side of a CDS position.” The problem is compounded by creditors not having to disclose derivatives positions, making it very difficult for companies and regulators to find out their real intentions. The study by the two University of Texas academics warns that the breakdown in the relationship between creditors and debtors, which traditionally worked together to keep solvent companies out of bankruptcy, lowers the system’s ability to deal with a credit crunch. “Spread across the economy, the ‘freezing’ of debtor-creditor relationships can increase systemic financial risk,” says the paper, which has been sent to the Securities and Exchange Commission. “[It] can also increase the economy’s exposure to liquidity shocks”.”

Lower Interest Rates Risk Dollar Decline
From Jim Grant: “In finance, to borrow from the economist Hyman Minsky, nothing is so destabilizing as stability. The paradox is easily explained. Profit-seeking people will take more financial risk when they believe the coast is clear. By taking bigger chances, however, they unwittingly make the world unsafe all over again. Anxious people don’t ordinarily get in over their heads; it’s the confident ones who do. And nothing builds confidence like the belief that a greater power has conquered the business cycle and laid inflation low. In such happy circumstances, a calculating human will take out a bigger mortgage, build a bigger hedge fund or attempt a gaudier corporate buyout. That is, he or she will borrow more money, or, as they say on Wall Street, lay on more leverage. So Americans proceeded to borrow. Over the past decade, household indebtedness, expressed as a percentage of the value of household assets, has shot up into record territory… To lubricate the machinery of lending and borrowing, Mr. Bernanke is likely to make dollars increasingly plentiful. The trouble is that, while the Fed is America’s central bank, the dollar is the world’s currency. It lines the vaults of central banks of America’s creditors, especially the up-and-coming states of Asia and the oil-soaked principalities of the Middle East. Such institutions hold dollars by choice, and not a few of them chafe at the greenback’s steady loss of purchasing power. For some, Tuesday’s hasty rate cut might be the last straw. As just about nobody predicted the present troubles, humility is what becomes today’s forecaster the most. So I will offer up a humble forecast. Inflation will, at length, make its way up from the bottom of the Fed’s worry list to the very top. Not for years has it seemed to matter that the dollar is only a piece of paper. But, before very long, that homely fact will push itself back to the fore.”

MISC
From Merrill Lynch: “All in all, we are off to the worst start to any year for the equity market (S&P 500 down 9.4% YTD) in over a century, and that is despite 175 basis points of rate cuts out of the Fed and a raft of policy proposals from Super SIV to FHA Secure to Hope Now to renewed fiscal largesse. In a sign of the times, we see on Bloomberg that so far in January, 24 IPOs have been pulled - the most in a decade…this was one oversold stock market - to be suffering these losses in December AND January? These are usually the two best months of the year, so if you were to "seasonally adjust" the market as you do for the economic data, it would suggest the bear market is even worse than it looks on the surface.”
From Wachovia: “There is little wonder why economics is known as the dismal science. Pessimistic views on the economy almost always seem to garner far more headlines and attention than supposedly optimistic predictions of moderating economic growth. Judging from today's headlines you would think that virtually every economist believes the U.S. economy is either heading for or is already in a recession. In fact, the latest Blue Chip Consensus shows economists rate the odds of a recession beginning in the next 12 months at just shy of 50 percent.”
From Morgan Stanley: “Subprime remittance deteriorated in November, supporting our underweight view. Deterioration in subprime loan pools suggests possibility of further CDO write-downs and higher losses and reserves against subprime loans.…We are underweight Large Cap Banks, expecting significant deterioration in loan quality throughout the year as housing values decline. We expect peak losses in first and second lien loans to be more than double prior recession cycle peaks and all other loan categories to generate losses in-line with prior recession cycle peaks. Banks are entering into this cycle with low reserves (we expect will have to double, eating into earnings) and thin capital. We don’t think the Fed rate cuts will sufficiently reliquify the banks.”
From Merrill Lynch: “Not only do the banks still have $230 billion of leveraged loans on their books, but according to the Investor’s Business Daily, regulators may force them to raise as much as $143 billion in fresh capital if the rating agencies sharply downgrade the monolines… Counterparty risk is the new theme in this credit mess – subprime was several chapters ago.”
From JP Morgan: “These actions justly mark the Bernanke Fed as “activist”: the central bank is willing to move policy aggressively in response to changes in its macroeconomic forecasts and perception of risks.”
From Merrill Lynch: “We look for national homeprices to be down at least 10.0% y/y in 2008 - and that implies a NEGATIVE wealth effect to the consumer of -$105.0 bln, or more. If a portion of the Bush $100.0 bln tax rebate is saved, then the negative housing wealth effect will dominate the stimulus package, calling forth ADDITIONAL Fed rate cuts.”
From Citi: “…large sales declines, price declines, and a hint of help from lower mortgage rates, have pushed affordability measures back above 20-year averages.”
From RBSGC: “Clearly, the steep cutbacks in housing starts have allowed significant progress in slowing the amount of supply in the pipeline. However, as long as new home sales are falling, builders will not be able to pare stocks, especially of finished homes, to desired levels very quickly. As a result, expect housing construction to keep falling for all of 2008 and stay focused on the sales data, which will provide the first evidence of a bottom.”
From BMO: “This will be the first real estate contraction since after World War I, which
begins at a time of a shrinkage in the numbers of twenty-somethings—the traditional first-time homebuyers. The demographic collapse that began 35 years ago will be a major factor in residential real estate pricing for many decades to come.”
From AFP: “"When folks buy a home they expect to die in it, I guess," she said as she stood outside in the cold. "I had my American Dream but it became a nightmare."”
From Wachovia: “The most direct way that an American recession would spread to the rest of the world is via the weaker exports to the United States. In that regard, Canada and Mexico stand out as being the most susceptible to an American downturn, especially a severe one. Although the European Union is the least exposed nation to exports to the United States, at least as measured as a percentage of local GDP, Europe does not have much cushion due to its relatively low overall GDP growth rate. Contrary to popular perceptions, the Chinese economy would not collapse if the United States experiences recession. Small open Asian economies, such as Singapore and Taiwan, might feel more of an impact, but these economies are better able to withstand an American downturn than they were during the last cycle. Most Latin economies probably would not fall apart either.”
From Citi: “ABCP yields remain slightly below Fed Funds at 3.44% while the spread to T-bills is at 140bp. Fed data shows a fourth consecutive weekly rise ($8.2bn) in US ABCP outstanding to $813bn in the week to 23 Jan. While the stock of ABCP is unlikely to return to its August highs ($1.2tr) just yet, its current level is a healthy improvement from the lows of $747bn at the start of the year.”
From BMO: “…quality corporates are too rare—with 71% of corporate debt junk-rated.”

From Deutsche Bank: “While US high yield credit spreads have widened to reflect an 11% default rate over the next year (vs. current default rate of <1%), the non-financial sector has not been increasing leverage to any meaningful amount. After repairing their balance sheets post the 2001 recession, the increase in leverage for the non-financials over the past few years has been minimal. The prime reason for the increase in leverage for the S&P500 over the past three years has been the marked increase in debt/book ratios amongst the financials (primarily brokers and money center banks), which are now paying the price. Conversely, the nonfinancials are in good financial shape to weather any slowdown/recession.”
From Thompson Financial: “Mining giant Rio Tinto projects that China's booming economy will consume more than half of the world's key resources within a decade, potentially leading to clashes with other countries over resources. Rio Tinto last week said China already accounted for 47% of all iron ore consumption, 32% of aluminum, and 25% of copper.”

End-of-Day Market Update
From UBS: “Relative to the roller coaster sessions we've seen last week, Treasuries had an absolute yawner of a day today. Richer early in the morning, Treasury yields gradually meandered upwards during the session, finishing little changed from yesterday's close… Swaps …spreads tightened modestly across the board…Versus Libor, 3-year agencies cheapened slightly, while the rest of the curve held in to swaps. Mortgages had a very quiet day, with the 5.5 coupon trading 3.5 ticks better to Treasuries and 2.5 to swaps, and 6's outperforming Treasuries by 1.5 ticks and swaps by a plus.”
From JP Morgan: “Indirect bidders were allotted just 19.3% of the auction, the lowest ever…This was a weak [2 year Treasury] auction and consistent with the (lack of) demand we saw.”
From RBSGC: “The 2s/10s curve steepened slightly during Monday's downtrade -- a dynamic which reflects the front-end's continued anchor to policy expectations. The Fed funds futures market is pricing in a 86% probability of a 50 bps ease -- as a half point becomes the consensus.”
Three month T-Bill yield rose 1 bp to 2.26%.
Two year T-Note yield rose 1.5 bp to 2.20%
Ten year T-Note yield rose 4 bp to 3.59%
Dow rose 177 to 12,384
S&P 500 rose 23 to 154
Dollar index fell .40 to 75.58
Yen at 106.9 per dollar Euro at 1.479 Gold rose $15 at $929. another record high
Oil rose $.37 to $91.08
*All prices as of 4:27pm