Today's Tidbits

Fed Vice-Chair Kohn Thinks It Will Take “A While” For Markets to Recover

From Goldman: “Kohn's comments suggests he still sees a substantial risk of significant further home price declines… One likely ramification of the current crisis is greater regulation of the financial industry, including regulation of leverage and systemwide buffers to financial shocks. Kohn's comments here suggested he sees over-reaction as a significant risk on the regulatory side. He noted that one role of the Federal Reserve is to "take some of the liquidity tail risk to facilitate intermediation of illiquid credits", and raising the prospect that increased regulation could simply encourage migration of financial activities to less-regulated sectors or jurisdictions. Kohn also implicitly raised the idea of regulatory forbearance in the current environment: “Among the challenges [to creating a regulatory system that deals effectively with cyclical pressures on credit] will be encouraging firms and supervisors to comfortably allow buffers to be eroded in bad times.”.. Kohn clearly suggest that he believes a recovery is some distance away. He stated that the “transition to the new steady state [of the financial system]…involves some overshooting--making terms and standards tighter than will be necessary over the long run." … he agreed with the implication of the paper that the "process of adjustment to a safer, more resilient financial system is going to take a while.”

US Government Not Eager To Bail Out Investment Banks

From The Financial Times: “The US authorities are desperately hoping that Lehman Brothers' efforts to find a private-sector solution to its troubles succeed - knowing that
failure to do so would force them to consider yet another large-scale bail-out. That choice would be a very difficult one, in part because of the lack of a proper legal framework for dealing with the orderly unwinding of investment banks. "There are no good options," one former policymaker told the Financial Times. US officials are anxious not to fuel moral hazard. "You have to draw the line somewhere," a second former official said. Yet there remains deep concern over systemic dangers. Moreover, experts worry that if Lehman succumbs, market pressure could simply shift to Merrill Lynch. Any decision on further public intervention will be made by Hank Paulson, the Treasury secretary, Tim Geithner, the New York Fed president, and Ben Bernanke, the Fed chairman. All these officials have a strong preference for a private sector solution. They are in a better position than they were at the time of the Bear Stearns rescue in March in some respects. The crisis at Bear was a shock. Lehman's problems are well known, and other market participants have had time to manage their exposures to it.
The new Fed Primary Dealer Credit Facility means it is very unlikely that Lehman would suffer the kind of sudden funding strike that sank Bear. If it did, it could turn to the Fed for finance. Access to Fed finance does not guarantee that an investment bank cannot disintegrate. But the facility should make any such process slower and more orderly.
The US authorities could decide this is enough. There is no guarantee of intervention.
Still, the Fed would want to avoid a situation in which it ended up funding Lehman's entire balance sheet without knowing these operations were being wound down. Moreover, the authorities may decide that even a slow-motion collapse of a leading investment bank is too risky, given the weak market infrastructure. There is no legal framework for adopting the kind of "conservatorship" arrangement used for Fannie Mae and Freddie Mac, or outright nationalisation. That is why the authorities had to find a proxy - JPMorgan Chase – to take over Bear Stearns and its trading positions, with a sweetener in terms of public funding for $29bn of problem assets. Finding a proxy was not easy then - it will be even harder now, given the state of the banking industry. A private equity-type buyer might be found, but could demand a prohibitive degree of public backing. Moreover, the Fed and the Treasury have a serious problem in structuring the public part of any intervention. While the Fed is happy to act as the government's agent in executing rescue operations, it wants the Treasury to make the decision to risk taxpayer money. The problem is that the Treasury can only spend money appropriated by Congress, putting the onus back on the Fed. Former Fed chairman Paul Volcker thinks its actions on Bear Stearns stretched its legal authority to the limit. One option would be to carve out the most systemically important parts of a failing institution - including its operations in the credit default swaps market and the triparty repo market - and back these with public support, while letting the rest fail. But it is not clear that this is legally possible.”

From FTN: “Moody’s says it will downgrade Lehman even if the firm raises capital because investors and counterparties have lost faith in the firm. Only if a majority stake is sold to a stronger partner will it keep its current rating. Lehman, meantime, continues to shop its Neuberger Fund unit, according to Bloomberg. CNBC, meanwhile, adds that some of the firms that continue to reiterate that they are doing business with Lehman are gradually cutting back their exposure. No question, the pressure is on. And, for the first time, we heard someone in the media – Joe Kernan at CNBC – question whether Hank Paulson’s decision to cut preferred equity holders off at the knees at Fannie and Freddie might make it more difficult for Lehman and others to raise capital. We suspect it won’t be long before others start to ask the same question. Joe gets extra points for remembering that Paulson himself was pushing the capital raise at the GSEs just a few months ago.”

From Bloomberg: “The Federal Reserve may have to increase the cash it provides to banks and brokers, already a record, to help them balance their books at the end of the year. Six bank failures in the past two months and rising concern about Lehman Brothers Holdings Inc.'s capital levels pushed lenders' borrowing costs to near a four-month high yesterday. They may climb further as companies rush for cash to settle trades and buttress their balance sheets at year-end.”

May See Unusual Drop in CPI Over Next Few Months

From Merrill Lynch: “The bond market is much like the stock market - it is a discounting mechanism… we are about to see a rather epic event. We think that there is a very good chance of seeing the August CPI come in at -0.1% (month-over-month) …A negative CPI print has occurred less than 10% of the time in the past - going back 60 years. Not only that, but if gasoline prices can manage to edge down to $3.50 a gallon from $3.70 currently (what it has done in the past month), then we also think there are no less than even-odds that we'll see a repeat of that -0.1% when the September data are released on October 16th. Now, back-to-back CPI declines are so rare that they have occurred less than 1% of the time in the past. Talk about the prospect of a seminal event ... not to mention how bullish this would be for Treasuries, notwithstanding the outlook for the fiscal deficit.”

Canadians Have Doubled Purchases of US Homes This Year

From The Financial Post: “Canadians have been flooding into the depressed U.S. housing market, purchasing a record number of homes south of the border, and twice as many as a year earlier. Armed with what until recently was a strong currency, most were also paying cash, according to the 2008 National Association of Realtors annual profile of international home buying activity in the United States. Canadians have replaced Mexicans as the top foreign buyers of U.S. properties, the survey revealed… The annual report, based on a survey of U.S. realtors, found that in the 12 months ended last May, nearly a quarter of foreign buyers of U.S. properties were from Canada, double the proportion of a year earlier, reflecting both a surge in Canadian buyers to a record high and a drop in purchases by other foreigners. "Condominiums were most popular among those foreign buyers from Canada," it said, noting that nearly half of all properties purchased by Canadian buyers were condominium apartments. Florida and Arizona were the most popular states for Canadian buyers, accounting for more than 60% of their purchases. The amounts Canadians paid for their properties were relatively modest compared with other foreign purchasers. The median price -- with half higher and half lower -- of properties purchased by Canadians was US$277,800, well below the US$450,000 by buyers from China, and less than the US$297,000 paid by all foreign buyers. Among the six top nationalities of foreign buyers of U.S. properties, only Mexicans paid a lower median price than Canadians… Foreign buyers, especially Canadians, were also much more likely than Americans to pay cash for their homes.
"In fact, buyers from Canada were more than twice as likely to purchase a U.S. home with cash than via any other method," it said, noting that 69% did so. That foreign buyers were more likely to pay cash for their homes may be because they tend to be relatively well off, or like Canadians, are not entitled to deduct mortgage interest payments, which makes it less attractive to take out a mortgage than it is for Americans.
Mr. Clinkard, meanwhile, predicted the shopping spree will likely cool as a result of the recent retreat in the value of the Canadian dollar, slowing income growth in Canada, and a firming of U.S. housing prices. "However, over the longer term, an increasing number of retiring Baby Boomers seeking relief from the winter chill will ensure that Canadians continue to be major foreign buyers of U.S. residential property for the foreseeable future," he added.”

MISC

From Bloomberg: “The Federal Reserve said lending to
commercial banks increased to the sixth record in eight weeks, while loans in an emergency program for securities firms showed a zero balance for the 11th straight week. The Fed report, based on data through yesterday, indicates that Lehman Brothers Holdings Inc. didn't tap the so-called Primary Dealer Credit Facility, an emergency source of credit created after Bear Stearns Cos. collapsed. Lending to commercial banks through the traditional discount window rose $820 million to a daily average of $19.8 billion. As of yesterday, commercial banks had $23.5 billion of discount-window loans outstanding, the Fed reported… The PDCF offers the 19 primary dealers that trade Treasuries with the New York Fed access to direct loans at the same 2.25 percent rate as commercial banks. Dealers can submit collateral including Treasuries and asset-backed debt, corporate bonds and municipal bonds with investment grades…The Fed's single-day record for discount-window lending is $45.5 billion on Sept. 12, 2001, the day after the terrorist attacks on the World Trade Center and the Pentagon.”

From UBS: ““Under our base case scenario (5% liquidation rate), the foreclosure level will peak in mid 2009 at $450 billion, or 1.83 million loans, compared to 1.65 million foreclosures reported by MBA for 2008 Q2.”

From LEHC: “The Metropolitan Regional Information Service released its report for home sales in the DC/VA/MD/WV area it covers, and the report showed some very divergent trends within the DC metro and the Baltimore metro areas. Home sales in most of the Northern Virginia jumped while median sales prices fell and listings plunged, with Prince William County – an area beset by surging foreclosures – saw massive sales gains, massive price declines, and a pretty big drop in listings. Most of Maryland, in contrast, saw only modest declines in median sales prices, but continued very weak sales and only modest declines in listings on the month – with listings still up from a year ago in most of the state… Maryland was a “top seven” state in terms of the gains in home prices relative to incomes during the 2001-2006 period, but the “boom” lagged NoVa by about a year, and the bust has not yet fully been reflected in home prices. In addition, the average “lag” from serious delinquency to REO is considerably shorter in Virginia than in Maryland, and many parts of Maryland have yet to see anything close to the full impact of rising REO sales on sales prices.”

From LEHC: “With the acquisition of Countrywide, BoA and Wells combined service $3.5 trillion of US residential mortgages, and the top four companies service $5.1 trillion (that’s somewhere around 37 million mortgages!). While many industry observers argue that “economies of scale” made massive consolidation in the industry “inevitable,” others are somewhat concerned about the “systemic risk” associated with the current industry concentration. Just last Spring a number of folks were worried about Countrywide, and the 9 million loans it serviced! “

From MNI: “A top-level delegation from Opec will travel to Moscow next month to forge closer ties between the oil producers cartel and Russia…”

From Barclays: “Silver falls over 4% to its lowest levels in over two years.”

End-of-Day Market Update

From Lehman: “Treasuries ripped higher out of the gate on Thursday as stocks fell hard amid financial sector turmoil, but equities rebounded, and traders hit the market hard off the highs to set up for today’s $12 billion ten year reopening. Tens sold off in a straight line from 3.56% to 3.64%, steepening out the yield curve in the process, and after a few hours chopping around from 3.62% to 3.64%, the market cheapened to 3.64% at 1:00. But the auction came 1.3 bp through the market, triggering a quick rally that was snuffed out equally quickly. Volumes continued to be robust, with over 1.1 mm ten year futures trading again today, and our flows were decent, but sporadic. We saw heavy short cover buying in the early morning run-up from trading accounts, decent selling from fast money around the highs in 5 year notes, steady selling of 2s from both mortgage and fast money accounts, and then very good buying of the ten year sector around the 3.64% level ahead of the auction. The yield curve steepened today, and 5s were a strong performer on the yield curve for much of the day, but they failed in the afternoon, and finished roughly unchanged to 2s and 10s.”

From RBSGC: “After holding a strong bid through much of the session, and through the $12 bn 10-year Reopening auction, prices ended relatively unchanged as domestic equities bounced off the lows. Thursday's Trade data did little to drive the Treasury market, with the ex-petroleum figures far less troubling than the headline, the firm Initial Jobless Claims and strong reception to the auction were the key bullish factors. The continued uncertainty in the financial sector weighed on equities early and produced safe-haven flows that refused to fade. While reopening auctions are typically non-events for the market, Thursdays 10-year was of note for a few reasons: 1) the 26.4% Indirect bid was twice the average, 2) there was no concession and it still stopped through 1.2 bps, and 3) it was the largest reopening auction since Sept '03, with the strongest indirects since June '04. We suspect the strong customer interest was a combination of both domestic and foreign accounts adding exposure as the global economic landscape becomes increasingly uncertain… The ongoing skittishness about the future of Lehman and the general outlook for the financial sector will likely provide a flight-to-quality backdrop to any downtrade, and we are wary of negative headlines from the sector leading sharp price action. In addition, as Fed expectations continue to be refined, the Fed Funds market is pricing in an increasing probability of rate-cut by year end -- with a 30% chance of a 25 bp move currently priced, there is room for these odds to increase next week -- particularly in the wake of the FOMC. The 2s/10s curve has steepened out about 6 bp this week, now safely through the channel top with the break projecting to the 148 bp steeps, with further upside beyond there. Fundamental support for this bias comes from the shifting monetary policy landscape, moderating inflation expectations as oil declines, and the underlying flight-to-quality dynamic outlined above -- we see much of this extending through year-end.”

From SunTrust: “The fate of Lehman and WaMu dominated conversation today. Shares are lower by 40% and 10% respectively. The removal of Fannie/Freddie from S&P 500 was another reminder just how low shares can go. Financial angst helped fed funds futures to price in a 12% chance of a rate cut next week, a 23% chance by October or a 33% by December. It also served to keep a bid in the Treasury market…. Agency spreads are close to unchanged on the day. FHLB priced $4 bln 5 yr bonds at +81.5. The book was well above $5 bln, but the GSE reportedly did not want to up-size.”

From UBS: “Swaps saw flattener trades, and spreads tightened roughly 1bp across the curve. Agencies underperformed Libor, with dealer-led 2-way flow in the 5-year sector. Late in the day, the FHLB priced $4B of its new 5-year issue at 81.5bps over 5-year Treasuries. FHLB debt cheapened roughly 2-3bps on the day versus Fannie and Freddie debt. Mortgages saw bank selling and roughly $1.5B of origination in the morning, pushing MBS 8 ticks wider to Treasuries and 5 worse to swaps. After some subsequent real money buying, mortgages tightened back in to only 3 wider versus Treasuries and 4 to swaps.”

From Bloomberg: “U.S. stocks advanced as a drop in oil prices spurred a rally in transportation companies, while banking shares staged a comeback in the last half hour of trading on speculation Lehman Brothers Holdings Inc. will be bought. The Standard & Poor's 500 Index rebounded from a 1.7 percent retreat and financial shares reversed a tumble of 4.2 percent to end the day up 1.5 percent. CSX Corp., the third-largest U.S.
railroad, climbed 11 percent and led the S&P 500 Transportation Index to its biggest gain since July as crude declined and the carrier raised its 2008 earnings forecast. Washington Mutual Inc. and Wells Fargo & Co. led the gain in banks as prospects of a Lehman takeover eased concern of more failures. The S&P 500 added 17.01 points, or 1.4 percent, to 1,249.05. The Dow Jones Industrial Average jumped 164.79 points, or 1.5 percent, to 11,433.71, erasing a 170-point drop. The Nasdaq Composite Index increased 29.52, or 1.3 percent, to 2,258.22. About three stocks rose for every two that fell on the New York Stock Exchange. In early trading, the S&P 500 fell below its lowest closing level since 2005 as Lehman slumped as much as 48 percent and dragged down all 87 financial companies in the index. Financial shares erased their drop as people with knowledge of the situation said other firms were reviewing Lehman's books in preparation for a possible takeover bid. The Wall Street Journal reported that Bank of America Corp. is among potential suiters. Fuel refiners Valero Energy Corp., Tesoro Corp. and Sunoco Inc. made up three of the top eight gains in the S&P 500 after the so-called crack spread on refining profits increased more than 35 percent. The spread is the hypothetical profit margin for processing three barrels of crude into two barrels of gasoline and one of heating oil.”

Prices as of 4:30
Three month T-Bill yield fell 3 bp at 1.61%
Two year T-Note yield rose 2.5 bp to 2.22%
Ten year T-Note yield rose 1 bp to 3.64%
30-year FNMA current coupon fell 2 bp to 5.22%
Dow rose 165 points to 11,434
S&P rose 17 points to 1249
Dollar index rose .23 points to 80.07
Yen at 107.5
Euro at 1.397
Gold fell $6.50 to $746