Today's Tidbits

Supply Replacement Still Important Constraint for Oil
From The Financial Times: “Output from the world’s oilfields is declining faster than previously thought, the first authoritative public study of the biggest fields shows. Without extra investment to raise production, the natural annual rate of output decline is 9.1 per cent, the International Energy Agency says in its annual report, the World Energy Outlook, a draft of which has been obtained by the Financial Times. The findings suggest the world will struggle to produce enough oil to make up for steep declines in existing fields, such as those in the North Sea, Russia and Alaska, and meet long-term demand. The effort will become even more acute as prices fall and investment decisions are delayed. The IEA, the oil watchdog, forecasts that China, India and other developing countries’ demand will require investments of $360bn each year until 2030. The agency says even with investment, the annual rate of output decline is 6.4 per cent. The decline will not necessarily be felt in the next few years because demand is slowing down, but with the expected slowdown in investment the eventual effect will be magnified, oil executives say. “The future rate of decline in output from producing oilfields as they mature is the single most important determinant of the amount of new capacity that will need to be built globally to meet demand,” the IEA says. The watchdog warned that the world needed to make a “significant increase in future investments just to maintain the current level of production”. The battle to replace mature oilfields’ output could even offset the decline in demand growth, which has given the industry – already struggling to find enough supply to meet needs, especially from China – a reprieve in the past few months…All the increase in oil demand until 2030 comes from emerging countries, while consumption in developed countries declines. As a result, the share of rich countries in global demand will drop from last year’s 59 per cent to less than half of the total in 2030. This is the clearest indication yet that the focus of the industry on the demand – not just the supply – side is moving away from the US, Europe and Japan, towards emerging nations.”
Short Sellers Rebut Evil Reputation for Being Bearish
From Bloomberg: “``Short selling is an expression of doubt, not a criminal activity,'' …``The management at Lehman, Bear Stearns and Merrill kept saying everything was fine. Then, every few weeks, they'd write off billions.' … The power of short sellers has been greatly exaggerated, says Douglas Kass, founder of Palm Beach, Florida-based hedge fund firm Seabreeze LP Holdings, which manages $200 million. ``The dedicated short pool totals about $5.5 billion,'' … ``Dedicated'' short-selling firms run funds that do nothing else. ``That's too small to have an impact,'' …The ban on short selling has exacerbated the financial crisis by driving dozens of hedge funds to the edge of bankruptcy, says Richard Baker, president of the Managed Funds Association, a hedge-fund-industry lobbying group. Quantitative hedge funds were put in the most jeopardy by the ban, he says. They use sophisticated computer algorithms to choose a group of stocks to buy. They then hedge the bet by shorting a second set of stocks. Their response to the short-selling ban has been to cut back on all trading, Baker says. Convertible bond funds have been hurt the most by the ban. Investors who buy convertible bonds -- bonds that can be converted to stock at a certain price -- usually short the same company's stock as a hedge against a fall in the price. Financial companies sold more than $30 billion of convertible bonds in the first nine months of 2008. In September, convertible bond arbitrage was the worst-hit hedge fund strategy, plunging 16.6 percent, … against a 6.9 percent fall for the industry. Most academic observers agree with Kass that the power of short sellers is overblown. ``In the current crisis, shorts are like flies on a carcass on the side of a road,'' says James Angel, a finance professor at Georgetown University in Washington who studies short selling. ``We should focus on who or what killed the animal.''…The short sellers have marshaled statistics in an effort to prove they played little or no role in the 2008 market downturn. Kass, for instance, points out that Morgan Stanley offers no data supporting CEO Mack's contention that short sellers were responsible when his company's stock price retreated 44.5 percent to an almost 10-year low of $22.55 in the three weeks ended on Sept. 18, the day short selling was banned. Morgan Stanley shares closed at $15.20 on Oct. 28, down 71 percent for the year. Data from custodians and brokerages compiled by London-based Data Explorers Ltd. show that as of Sept. 16, about 2.9 percent of Morgan Stanley's outstanding shares had been loaned to short sellers, down from more than 7 percent in July. According to Short Alert Research, a Charlotte, North Carolina-based firm that produces research for short sellers, from early July to late September short interest in 33 investment banks and brokers plunged by 33.3 percent. Yet, share prices still declined. ``It was the longs getting out,'' says Fleckenstein. ``Probably the insiders.''…the
SEC's short-selling ban and the federal government's $700 billion bailout package just postponed the day of reckoning. ``Capitalism is all about boom and bust,'' he says as he scans e-mails and monitors stock prices. ``To ban short selling is to say that the government is going to determine what stock prices should be.''
Fed Pushing Exchanges to Create Clearinghouse for OTC Credit Default Swaps
From Bloomberg: “The Federal Reserve has given U.S. futures exchanges until Oct. 31 to present written plans on how they'll make the $55 trillion credit swaps market less risky, according to four people familiar with the discussions. CME Group Inc. and Intercontinental Exchange Inc., the two biggest U.S. futures markets, are among companies vying for a share of the market for guaranteeing credit-default swaps, the volatile contracts blamed for the current financial crisis. …The Fed is pressing the industry to set up a central counterparty that would absorb losses should a market maker fail, a step that might have avoided last month's bankruptcy of Lehman Brothers Holdings Inc. The process may be heading toward a conclusion, said Brian Yelvington, a strategist at fixed- income research firm CreditSights Inc. in New York…. ``You're going to see one of these solutions come to fruition in the next four weeks.'' The Federal Reserve Bank of New York is seeking details on how credit-default swaps would be settled by a clearinghouse, how trades would be processed, what safeguards are in place in the event of a trader bankruptcy and how the system will insure against a meltdown similar to Lehman Brothers… Federal Reserve officials are not aiming to pick a winner to operate a clearinghouse, the people said. Rather, the central bank is hoping to set up a framework for the eventual winner…. Regulatory approvals to enact a framework may be in place as early as mid-November, the people said. Credit-default swaps pay buyers face value for the nderlying securities, or a cash equivalent, should the company fail to keep to its debt agreements. The swaps are blamed for hastening the bankruptcy of Lehman Brothers by driving down the investment bank's equity value. Because CDS contracts are traded bilaterally by banks, hedge funds, insurance companies and other institutional investors, each party faces the risk of losses should their trading partners default. A clearinghouse, capitalized by its members, all but eliminates the risk of trading-partner default by being the buyer for every seller and the seller for every buyer. It employs daily mark-to-market pricing and liquidates positions of traders who can't pay their margin. The four groups vying to operate clearing operations include partnerships of Chicago-based CME Group and Citadel Investment Group LLC, and Intercontinental Exchange, dealer- owned Clearing Corp. and credit-swap index owner Markit Group Ltd. Eurex AG and NYSE Euronext also have submitted proposals.”
International Trade Growth Has Rapidly Contracted Due to Fewer letters of Credit
From Bloomberg: “The inability of buyers in China and Vietnam to get letters of credit has cost his company as much as $4 million this year, a third of projected revenue, forcing him to lay off 15 of 35 employees, he said. Suppliers of oil, coal, grains and consumer products from Chicago to Mumbai are losing sales as the credit crisis spreads beyond financial institutions, and banks refuse financing or increase the fees for buyers. Coupled with declining demand, the credit squeeze is threatening international trade, one of the lone bright spots in the global economy… Emerging markets such as Brazil, Vietnam and South Africa are particularly vulnerable because buyers have more trouble proving their financial strength. The slowdown is also damaging the U.S., the world's largest economy, where exports accounted for almost two-thirds of the 2.1 percent growth in gross domestic product in the 12 months through June, according to the U.S.
Trade Representative's office. Another sign of trouble: The Baltic Dry Index, a measure of commodity shipping costs that banks watch as an economic indicator, fell below 1,000 yesterday for the first time in six years, dropping it 89 percent for the year. Global trade volumes may sink next year, their first decrease since 1982, according to Andrew Burns, a lead economist at the World Bank. While there is still uncertainty over future prospects, trade may contract by as much as 2 percent, after annual increases of 5 percent to 10 percent over the past decade. `We only see this kind of shock when we have outbreaks of war, or maybe the oil shocks of the 1970s,'' …. ``This lack of credit was a shock to the entire economy. We were hit second after the banks.'' Of the $13.6 trillion of goods traded worldwide, 90 percent rely on letters of credit or related forms of financing and guarantees such as trade credit insurance, according to the Geneva-based World Trade Organization. Letters of credit are centuries-old instruments that allow far-flung partners to complete large transactions. An importing company gets its bank to issue the letter, guaranteeing payment for a delivery. That bank provides the letter to the exporter's bank, which then guarantees payment to the exporting company. The system breaks down when banks don't trust one another and are unwilling to accept a letter of credit as proof that payment is coming. From 2000 through last year, the use of letters of credit declined to about 10 percent of global trade transactions, the IFC's Stevenson said. Over the past six months, they began ``roaring back into fashion'' as sellers sought to guarantee
payments from buyers they no longer trusted, he said. At the same time, liquidity problems caused banks to increase charges. The cost of a letter of credit has tripled for buyers in China and Turkey and doubled for Pakistan, Argentina and Bangladesh, said Uwe Noll, director of country risk sales at Deutsche Bank AG. Banks are now charging 1.5 percent of the value of the transaction for credit guarantees for some Chinese transactions, bankers say. ``The whole global trade production line relies on letters of credit,'' Matt Robinson, an analyst at Moody's Economy.com wrote in an Oct. 23 report. ``No letters of credit, no transactions -- and no transactions mean no international trade.'' The evidence is piling up in the world's ports…. ``This is absolutely a crisis situation here,'' … the demise of his deals with Asian buyers also reflects the weakness of the U.S. economy, including a slowdown in construction that has reduced demand for the wood products companies such as Shanghai VIVA make. Liu Jian Jun, manager of Shanghai VIVA, said weak demand inthe U.S. and elsewhere killed the deal with Cross Creek, not access to credit…. ``We've become more cautious,'' Ng said, blaming the
retrenchment on a decline in the number of credit-worthy customers. Bank bailouts funded by the U.S. and other governments have begun to ease liquidity problems. ``But we still have credit issues,'' he said. ``And they are going to get worse, not better, because the economy is getting worse.''”
End-of-Day Market Update
From UBS: “Yields rose from the belly of the curve out to the long bond and the UST2Y10Y curve steepened to 230 bps post rate cut. The market is grappling with the prospects of deteriorating data, possible further monetary accommodation, and massive forward supply. It will be difficult, however, for the front end of the curve to escape the gravitational pull of a 1% Fed Funds rate, especially when faced with the potential further easing in the pipeline. The UST 2 Year is currently about 50 bps over the Fed Funds Rate, which may represent fair value at this point. …Libor was set 4.5 bps lower today at 3.42%. The Dow closed -74 at 8,990. The CRB was +15.3 at 274. Oil ws $68.05/bbl, +$8.48. Treasury volume was -27% below the 30 day mva. The day of the last scheduled rate decision, September 16th, it was 71% above the 30 day mva…: UBS Economics Forecasts More Cuts to Come: The Fed rate cut was the predictable highpoint of the day. While the -50 bps cut was widely forecast, the statement was analyzed for signs of future intent. UBS Economics now forecasts a terminal Fed Funds Rate of 0.50%, with a -25 bps cut in December and -25 bps in January. In other news, more entities are trying to obtain government reprieves, outright funding, or guarantees to address their special interests. The Committee on Investment of Employee benefits is petitioning Congress for relief from provisions of the Pension Protection Act of 2006. The rapid erosion of financial assets has left many defined benefit plans with a gaping asset-liability mismatch. The rules begin to be implemented as of 12/31/08 with effect in 2009. Penalties are onerous and in some cases obligations could fall into the Pension Benefit Guaranty Corporation (Bloomberg). Treasury and FDIC are in the process of finalizing details for a proposed government guarantee plan for troubled mortgages. Loan guarantees of up to $500B will be used as incentives to servicers in the hope that this will encourage them to modify loans (Bloomberg). ..Spreads narrowed against the backdrop of relatively low realized rate volatility, a -50 bps rate cut and a statement which left the door open to more accommodation, and a relatively anxiety free trade in the equity and f/x markets. Stability breeds confidence which enables risk taking. Swap spreads narrowed -5 bps to 112.5 in 2Y, -5.5 bps in 5Y to 106.5, -4.25 bps in 10Y to 49.0, and -0.5 bps in 30Y to 4.0 bps. GSE benchmarks also narrowed with 2Y -4.0 to 145, 5Y -90 to 148, and 10Y -9.5 to 121.5. We continue to believe that short GSE spreads represent good value. MBS do not appear to be trading well, as they closed at +200 bps against a 50/50 weighting of 5Y & 10Y swaps. Lack of buyers and forced sellers seems to be the order of business.“
Prices as of 5PM (Based on Bloomberg)
Three month T-Bill yield fell 17 bp to 0.58%
Two year T-Note fell 11 bp to 1.53%
Ten year T-Note yield rose 2bp to 3.85%
30-year FNMA current coupon steady at 6.06%
Dow fell 74 points to 8991
S&P fell 10 points to 930
Dollar index fell 2.39 points to 84.64
Yen at 97.5
Euro at 1.29
Gold rose $10 to $756
Oil rose $5.50 to $68.25