CPI Unexpectedly Doesn't rise in February

A -.5% MoM drop in energy prices (and a -2% MoM decline in gasoline prices) enabled both the headline and core CPI prices to remain unchanged month-on-month in February. The market had been expecting an increase of +.3% MoM for the headline CPI and +.2% MoM for core. This is the first time the core, which excludes food and energy costs, hasn't risen since November 2006 on a monthly basis. The decline in energy costs was led by the largest drop in electricity prices in over two years. Unfortunately, the record prices for oil and natural gas this month indicate this pause in energy price inflation was fleeting. Excluding energy costs, the CPI rose +.1% MoM in February, as is up +2.6% YoY. The year-over-year increase in inflation was also smaller than expected. Headline inflation fell to +4% YoY from +4.3% in January, and core CPI fell to 2.3% YoY from +2.5% YoY in January. Energy prices have risen +19% YoY, at the consumer level, food prices have risen +4.6% YoY. Price declines were broad-based in February, as the prices for clothing (-.3% MoM, -1% YoY), vehicles (+.2% MoM, unch YoY) and airfares all dropped. Medical care costs saw the smallest monthly rise in almost a year, at +.7% MoM (+4.5% YoY). Housing costs also rose more moderately than expected, as the overhang of housing is slowing the rise in rental costs. Actual tenant rents were unchanged in February. Owners equivalent rent rose only +.1% MoM, down noticeably from the +.3% MoM gains of the prior three months. Housing costs have a heavy weighting in the CPI at 42.4% of the total. Personal computer costs continue to deflate, falling -.5% MoM and -12% YoY. The CPI is one of the broadest inflation measures, as it includes goods and services. The decline in inflation gives the Fed more room to cut rates at the next FOMC meeting. Many economists are predicting a decline of 75bps. The futures market agrees and is currently pricing in a 100% chance of a 75bp cut next week. Ten year Treasury yields are now 9bp lower versus last nights close to 3.44%. The dollar is unchanged.

Retail Sales Weaken

Retail sales unexpectedly fell -.6% MoM in February (consensus +.2% MoM). January's reading was revised slightly higher by +.1% to +.4% MoM, but December's was revised down by -.3%. Motor vehicle sales were very soft, falling -1.9% MoM, followed by falling gasoline station sales of -1% MoM. Excluding autos and gas, retail sales only fell -.1% MoM. Auto sales are sitting near a three year low. The drop in gasoline sales is a bit of a surprise, and indicates that higher prices are causing consumers to cut back on unnecessary travel. But, gasoline sales are still up over 20% YoY due to the higher prices. Housing related categories remain under stress with building material purchases falling -.7% MoM, furniture sales falling -.5% MoM and electronics sales declining by -.4% MoM. Excluding autos, gasoline, and building materials, sales were unchanged in February. This figure is used for calculating GDP. Data for the excluded categories is gathered from other sources. Food and beverage sales also decreased by -.2% MoM. Categories seeing growth included health care at +.5% MoM and general merchandise +.4% MoM( though department store sales fell -.2% MoM). Restaurant sales, which are typically viewed as a good consumer sentiment indicator, saw a -.4% drop, the largest in over a year. Over the past year, retail sales have risen +6.8% YoY. When autos and building materials, which have been weak are excluded, growth was a stronger +9.7% YoY for the rest of the economy. Excluding gas, retail purchases grew +5% YoY. Economists are becoming increasingly concerned that retail sales in the first quarter will fall to the lowest level since the recession of the early 1990s. More economists now believe the U.S. has entered a recession, as employment drops and credit grows tighter. Data from MasterCard showed the largest monthly decline in spending (-1.1% MoM) in at least five years. The drop may be partially due to credit lines being reduced for many accounts.
************
Initial and continuing jobless claims both rise slightly from the week before

Import Price Growth More Restrained Than Anticipated

Retail sales rose +.2% MoM (consensus +.8%) and +13.6% YoY (consensus +14%) in February. January's record rise was pushed higher to 13.8% YoY from the previously reported +13.7% annual gain. The petroleum prices have risen over 60% YoY, they fell -1.5% MoM in February. Excluding petroleum, which has been the major driver of higher import prices this past year, import prices rose a much slower +4.5% YoY for all other categories of goods. Other categories which have experienced large import price increases over the past year include industrial supplies (+35% YoY) and foods (+11% YoY). But, imported food costs fell in February by -.1%, the first monthly decline in almost a year. The largest price increases this year have been coming from Canada at +13.7% YoY. This is a combination of the stronger Canadian dollar, and the large importation of energy products from Canada. Canada is not the U.S.'s second largest trading partner behind China. China became the largest trading partner last year, and Chinese import prices rose a more moderate +3.4% YoY, though still a new record high. China is no longer spreading deflation. Japanese import prices are also slowly trending higher. A reduction in inflation will help reduce the erosion of U.S. workers purchasing power. The dollar has fallen about 10% over the past year versus a basket of major trading partner currencies. Unfortunately, most of this month's improvement was in imported petroleum costs, which we know will not continue, as oil has risen to new record highs in March. Excluding petroleum, import prices rose +.6% MoM.

U of Michigan Confidence Falls to Lowest Level Since 1992 and Inflation Expectations Shoot Higher

The preliminary March University of Michigan consumer confidence number only worsened slightly to 70.5, from 70.8 in February. The market had been looking for a steeper decline to 69.5, but this is still the lowest reading in 16 years (1992). Current conditions rose to 84.6 from 83.8, while future expectations eased to 61.4 from 62.4 last month. The one year inflation expectations exploded higher to +4.5% from +3.6%. This will seriously disturb the Fed. On the other hand, the five year inflation expectation eased slightly to 2.9% from 3%. Clearly record food and energy costs are weighing on consumers minds as jobs are being lost. Tightening credit conditions are now feeding through to even those that aren't refinancing mortgages, as credit card lines are being cut for many consumers.

End-of-Day Market Update

From SunTrust: “Armageddon seemed to be near this morning with the collapse of another hedge fund, but things changed swiftly and with great magnitude. Paulson was flapping his gums regarding regulatory changes (too late) about the same time Barney Frank proposed another government bail-out. The tape bomb that turned the markets around sharply, however, was the comment from S&P that banks may be nearing the end of sub-prime write-downs. They opine that losses will amount to $285 bln and that the market is "past the halfway mark". The DOW moved from -220 points to +88 points in short order. Treasury coupons took about a 20 bp swing from high to low today alone. Adding further insult, the Treasury auctioned $10 bln 10 yr notes to an unenthusiastic crowd…This has been a vicious week for volatility. Tuesday's 30 bp move in 2 yrs was one of the largest daily moves in over a decade. Intra-day swings in 10's have totalled over 80 bp this week.”
From Lehman: “The treasury market opened with a big bid on the back of weak global equities, dollar/yen below 100, higher gold (explain again to me why higher gold is good
for bonds?) and a continuation of the general state of disarray. But the market came off the highs as stocks turned and dealers set up for 10 year supply, and an abysmal auction set the tone for the rest of the day. Post-auction, the market continued to sell off, led by selling of the back end…Flows were mixed, and both mortgage and fast money accounts
were active buyers in the early run-up. But when the market turned, it turned hard, spurred by a rebound in equities, and dealer selling into 10 year supply. A story that S&P said that the "end is in sight" for subprime loss writedowns at major financial institutions also got a bunch of play right around the market's turn, but we think people are in a still in a "we'll believe it when we see it" mode when it comes to these things…Despite a very good concession, the 10 year note tailed about 3 basis points, as indirect bids totaled just 5-6%, leaving dealers to buy, and then quickly sell, the balance. The downtrade was a little messy…The yield curve steepened quite a bit…”
From Deutsche Bank: “These markets just aren’t getting any easier. In Asian time yesterday, equity markets stumbled badly on the news that Carlyle Capital Group had been unable to reach agreement with its lenders, likely forcing the company to hand over the remaining collateral underpinning its mortgage bond fund. And with the US retail sales report for February disappointing as well the North American session was shaping up to be an ugly one. But after trading well in the red early in the session, the US equity market has not only pared those losses, but actually moved into the black. The catalyst seems to have been comments from S&P suggesting that the end of the subprime writedown process is now in sight, at least for the world’s major financial institutions. After the experience of the past 12 months, it seems amazing to this writer that the opinions of the rating agencies carry such force!”
From Bloomberg: “U.S. stocks rose for the second day this week after Standard & Poor's predicted an end to banks' subprime mortgage writedowns and gold surged above $1,000 an ounce, sparking a rally in mining shares…Fannie Mae, the biggest provider of money for U.S. mortgages, helped financial shares recover from a 4 percent decline after S&P said banks have already disclosed the majority of their writedowns. The S&P 500 added 6.7 points, or 0.5 percent, to 1,315.47 after dropping as much as 2 percent. The Dow Jones Industrial Average climbed 35.5, or 0.3 percent, to 12,145.74. The Nasdaq Composite Index rallied 19.74, or 0.9 percent, to 2,263.61. Almost five stocks rose for every two that fell on the New York Stock Exchange…Stocks tumbled earlier after the $16.6 billion default at a Carlyle Group bond fund added to turbulence in financial markets, and an unexpected drop in retail sales signaled the economy has slid into a recession. Nine of 10 industry groups in the S&P 500 advanced, after all 10 opened the day lower. Raw-materials producers gained the most, climbing 2 percent as a group. Gold rose above $1,000 an ounce for the first time as mounting credit-market losses spurred demand for bullion as a haven from the sagging dollar.”
From Bloomberg: “The dollar fell below 100 yen earlier today for the first time since 1995 and set a record low against the euro after a Carlyle Group fund defaulted on about $16.6 billion of debt, adding to turmoil in financial markets…The U.S. currency fell against a basket of six major trading partners to the lowest since the index began in 1973 …Japan sold yen on the four occasions since 1995 when the currency approached 100 to support exporters…The yen's 24 percent gain against the dollar from a 4 1/2-year low on June 22 will damage earnings, Toyota President Katsuaki Watanabe said today…The yen also gained as investors exited so-called carry trades, in which they borrow in a country with low interest rates and buy higher-yielding assets elsewhere, earning the spread between the two. The risk is that currency moves erase those profits…Japan's benchmark rate of 0.5 percent compares with 3 percent in the U.S., 4 percent in Europe, 7.25 percent in Australia and 8.25 percent in New Zealand.”
From UBS: “The Treasury market had a good morning going after troubles at Carlyle and weak stocks sent the Treasury 2yr yield back below 1.50%. Treasury prices then reversed course (lower) when the Chairman of the House Financial Services Committee, Barney Frank, unveiled a $300B plan to rescue the housing and mortgage markets. We saw central bank buyers of 10-year coupon paper and 2-way flow in intermediates, and the 2s10s curve steepened nearly 7bps on the day as intermediates underperformed in the sell-off. TIPS lagged nominals across the board, especially in the belly of the curve. Treasury volume was 110% of the 30-day average… swap curve went from flatter on the day to steeper. Spreads blew out early in the session as the world appeared to be in full-meltdown mode, then came in 7-9bps off their wides to finish tighter on the day. Agencies saw better selling in the front end and buying in the belly-- underperforming swaps by 2bps in the front end and 5bps further out on the curve. 5- and 10-year agencies are now at new historic wides versus Libor. Mortgages saw heavy selling this morning, going out to about 28 ticks wider to Treasuries. After the S&P announcement and the rescue package headlines hit the wires, we saw fast money buying, and mortgages went all the way back to unchanged to Treasuries on the day. Whew...”
Three month T-Bill yield fell 5 bp to 1.36%.
Two year T-Note yield rose 1. bp to 1.63%
Ten year T-Note yield rose 7 bp to 3.53%
Dow rose 36 to 12,146
S&P 500 rose 7 to 1315.5
Dollar index fell .50 to 71.90
Yen at 100.6 per dollar
Euro at 1.563
Gold rose $12 to $995
Oil rose $0.28 to $110.20
*All prices as of 5:00 PM

Impact of Fed Announcement on Treasuries

As of 9:30 AM
3m T-bill +10bp to 1.45%
2y US Treasury Note +22.5bp to 1.71%
5Y +22bp to 2.59%
10y +11bp to 3.56%
30y +4bp to 4.50%
**********************
Treasuries Decline as Fed to Accept Agency Debt as Collateral
2008-03-11 08:58 (New York)
By Sandra Hernandez
 March 11 (Bloomberg) -- Treasuries fell, pushing the two-year note's yield up the most since July 1996, as the Federal Reserve's move to relieve the credit crisis prompted investors to dump holdings of government debt. Shorter-term notes led the decline as the central bank said it will allow securities firms to pledge agency and private mortgage debt as collateral against as much as $200 billion in Treasury securities. Investors and securities firms have been hoarding government debt, considered the safest and most easily traded securities, amid the credit crunch. ``This is obviously very good news,'' said James Caron, head of U.S. interest-rate strategy at Morgan Stanley in NewYork. ``They're providing liquidity to those who need it the most.'' The two-year note's yield climbed 27 basis points, or 0.27percentage point, to 1.77 percent at 8:56 a.m. in New York, according to bond broker Cantor Fitzgerald LP. The price of 2 percent security due February 2010 dropped 17/32, or $5.31 per $1,000 face amount, to 100 14/32.
--Editors: Dennis Fitzgerald, Dave Liedtka

End-of-Day Market Update

From Suntrust: "At least for today, the FED's surprise announcement had its intended effect. Equities are 4% higher, the largest one-day gain in 5 years. Financial shares were especially boosted by the news. Spreads in sister markets came in nicely. Agency spreads narrowed 10-15 bp, broker names in the corporate market are 10 bp tighter, some of the MBS market snapped in by a full point in relation to Treasuries. This has all been at the expense of the Treasury market, which is headed into the close near the day's lows. 2 yr notes were hit the hardest, 26 bp higher in yield vs yesterday. The bond outperformed, rising only 7 bp on the day. The 2/10 curve narrowed to a spread of +183 bp vs +210 last week. Now the question becomes, will it last? One pundit pointed out that as of 02/27, primary dealers held in position approximately $140 bln agencies and $60 bln agency MBS securities, exactly the amount to be auctioned by the TSLF. In light of today's move by the FED, it is uncertain whether the FED will deliver 75 bp next Tuesday." From Deutsche Bank: "Equities rebound strongly as Fed takes further action to ease funding pressures, credit and swap spreads narrow, Dollar rebounds from early weakness... AAA/Aaa rated private-label residential MBS. According to our US economics team the details are still light, but they interpret this to include AAA subprime and Alt-A mortgage securities. And, they expect that the Fed will be lending out bills in exchange for mortgage collateral. The intention of this auction lending facility, which goes into effect on 27 March, is to provide more liquidity to the mortgage market and to make Treasuries less special, especially as the fed funds rate is reduced further. - While these are important steps in helping restore order, they fall short of some investors' expectations that the Fed would purchase agency/agency MBS debt outright. Additionally, these actions do not deal with constraints on bank balance sheets. Nonetheless, equity markets have greeted the news with the Dow up ...In debt markets, Treasury yields are up significantly and swap and credit spreads have narrowed. Even the beleaguered Dollar was given a lift by the news." From UBS: "Treasuries plunged this morning after the Fed disclosed its plan to lend $200 billion in Treasuries, while equities celebrated with the Dow Industrials up as much as 366 points late in the afternoon. In the minutes immediately following the announcement, 2-year yields spiked over 20bps, trading as high as 33bps higher than yesterday's close. 5-year yields also briefly went north of 30bps cheaper on the day, and the 2s30s curve flattened nearly 20bps as the market saw a lower likelihood of a large rate cut next week...TIPS outperformed nominals for the most part, and the breakeven curve flattened by 7bps. Treasury volume was a healthy 120% of the 30-day average...[Swap] spreads narrowed by double-digit basis points across the curve immediately following the Fed announcement. Since then, swap spreads have bounced off their lows by 2-3bps, though 2-year spreads are still tighter by 12bps. The Fed news was also obviously good for mortgages, which spent the day trading between 16 and 32 ticks tighter to Treasuries as a result of short squeezes....Agencies cheapened to Libor by 2bps in the front end, but outperformed swaps in 10-year space." From RBSGC: "The Fed delivered an expedited form of liquidity creativity which went a long, if temporary, way of addressing financing problems within the dealer community, first and foremost, and the system in general. This is, of course, the TSLF whose details are partially addressed above. Our quick take is that this gets the dealer community over an immediate 'crisis' of financing and will likely be an ongoing effort for 2008. This buys the dealers some time as they can, at least finance difficult positions. It does NOT, however, help them unload paper (and thereby free up balance sheet for other purposes) nor does it directly help finance non-qualifying assets. As discussed in Monday's Closing Notes, there are some efforts afoot to take the paper out of the system's hand. Sen. Dodd plans to introduce legislation to create a government corporation to actually buy mortgages. Presumably, the Fed could buy for the SOMA, too, but today's action clearly demonstrates they don't want to. The bond market responded as you might expect. Treasuries fell in price and the curve flattened; swap spreads tightened, and MBS tightened to Treasuries. It was all quite dramatic and initially on very good volume. We think the price action has some room to go -- i.e. flatter, cheaper -- as this new process is taken in by the market. Too, there is a chance that the Fed's action today skews the risk to a 'mere' 50 bp cut at the end of March -- that's our bet. And so with the steepening already crowded we see position unwinds as helping to further the price action underway. There is certainly NOT a lot else going on in terms of data or speakers and given that MBS financing has been such a central focus we can only anticipate the Fed's liquidity provision will prove more than a one-day-wonder and so prove a drag on the Treasury market as the process pans out...We do not think the Fed's liquidity provision vis TSLF marks the start of the end of the liquidity crisis let alone the economic cycle. Indeed, we envision that the price action in mortgages and other structures in Q1 will be reflected in more writedowns as earnings are announced. Further, there is an economic story to go with the dealers' problems. Don't mistake a change in prices for a change in facts (economic facts, anyway)." From Bloomberg: "U.S. stocks rallied the most in five years after the Federal Reserve said it will pump $200 billion into the financial system to shore up banks battered by mortgage-related losses. Washington Mutual Inc. climbed the most since 2000 on speculation the largest savings and loan will get a cash infusion from an outside investor. Citigroup Inc., Wells Fargo & Co. and Bank of America Corp. led the Standard & Poor's 500 Financials Index to its biggest gain in eight years on expectations the Fed's move will spur lending. All 10 industry groups in the S&P 500 rose except for health-care companies. Stocks in Europe and Asia gained. The S&P 500 added 47.28 points, or 3.7 percent, to 1,320.65, trimming its decline for the year to 10 percent. The Dow Jones Industrial Average surged 416.66, or 3.6 percent, to 12,156.81. The Nasdaq Composite Index increased 86.42, or 4 percent, to 2,255.76. Eleven stocks gained for every one that fell on the New York Stock Exchange...The S&P 500 rebounded from the lowest level since August 2006 as 479 of its members advanced. Treasuries fell, pushing two- and five-year note yields up the most since 2004, as investors dumped holdings of government debt and bought stocks. The dollar rose the most in six months against the yen and rebounded from a record low versus the euro...Fannie Mae, the biggest provider of financing for U.S. mortgages, added $2.19 to $22. Freddie Mac, the second-largest, rose $2.77 to $20.16. Countrywide Financial Corp., the biggest U.S. mortgage lender, climbed 75 cents to $5.11. Washington Mutual added $1.84, or 18 percent, to $11.88."
Three month T-Bill yield rose 12 bp to 1.47%
Two year T-Note yield rose 26 bp to 1.74%
Ten year T-Note yield rose 13.5 bp to 3.59%
Dow rose 417 to 12,157
S&P 500 rose 47 to 1321
Dollar index rose 0.26 to 73.25
Yen at 103.4 per dollar
Euro at 1.534
Gold unchanged at $973
Oil rose $0.70 to $108.60 (Record High)
*All prices as of 4:58 PM

Some Dealer Comments on Fed's Announcement

From Goldman Sachs:  “In yet another move designed to unclog financial markets and ease tensions on the credit side, the Federal Reserve has announced an expansion of its securities lending function.  It plans to make available up to $200bn in Treasury securities and to accept as collateral a fairly wide range of mortgage-related securities, including: federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS.  Unlike the curent program, which is mainly overnight loans, the expanded facility (termed the Term Securities Lending Facility), the loans will be available for 28-day terms.

Alongside this announcement, the Fed has expanded wap lines with the ECB and SNB, to $30bn (an increase of $10bn) and $6bn (an increase of $2bn), respectively.

This announcement makes clear that Fed officials are pulling out all stops they can think of to deal with financial stress through the increased provision of liquidity into the system.  To the extent they see this as substituting for rate cuts, this should reduce the probability (which we have regarded as low all along) of a 75bp rate cut next Tuesday.  A 50bp rate cut remains the most likely option on March 18.”

From Bank of America:  “This addresses many of the financing issues for private label MBS.  It does not address the capital shortfall in the system, or the risk in the underlyingsecurities.  But, since it is likely to substantially lower financing costs for AAA rated MBS, it will improve the carry on these securities and make positions a bit easier to hold. Odd structure addresses some of the restrictions on the Fed owning private label MBS.  Basically, the dealer gives the Fed MBS collateral, the Fed gives back Treasury collateral, and the dealer pays a rate determined by the auction.  Since these will be term loans, some Tsy collateral will get tied up in the auction, and we may see a bit more quarter-end specialness in some issues.”

Trade Deficit Smaller than Expected in January

The U.S. trade deficit was smaller than expected in January, and was also revised to a smaller figure for December.  The January deficit was -$58.2B (consensus -$59.5B), and December was revised narrower by $0.9B to -$57.9B. 

 

Higher exports were the main cause of the improvement as foreign demand for U.S. goods and services rose +1.6% MoM to a record high of $148B in January.  The weaker dollar (-10% YoY) is helping support export demand as U.S. goods, which are becoming more price competitive with overseas products, but it also means that raw materials, such as crude oil, are becoming more expensive.  Export growth is one of the few positives for GDP growth at the moment, and impacts everything from manufacturing to agricultural goods.  The reduced trade deficit may help GDP growth in the first quarter.

 

Imports grew +1.3% MoM, and are also at a record high pushed higher by rising prices, and volumes, of crude imports in January.  Remeber that crude oil first hit $100 in January of this year.  If petroluem imports are excluded, the trade gap was only $32.1B, the smallest since 2002.  This month, the oil deficit exceeded the deficit for the rest of the economy for the first time since 1992 as demand for other consumer products from abroad is easing.  Domestic purchases of TVs, clothes, toys and appliances all dropped last month, as the U.S. economy slows.  As businesses become more careful, they also reduced demand for for machinery and computers produced overseas in January.

 

The trade gap with China rose to $20.3B.  China rose to become the U.S.'s largest trade partner last year, pushing Canada into second place.  The trade gap with the European Union was the smallest since 2002.

 

Federal Reserve Announces Plan to Lend $200 Billion (Text)

Federal Reserve Announces Plan to Lend $200 Billion (Text)
2008-03-11 08:36 (New York)

 

By Christopher Anstey
     March 11 (Bloomberg) -- Following is the text of the
statement released by the Federal Reserve today on plans to lend
up to $200 billion through a new liquidity tool.

 

Since the coordinated actions taken in December 2007, the G-10
central banks have continued to work together closely and to
consult regularly on liquidity pressures in funding markets.
Pressures in some of these markets have recently increased
again. We all continue to work together and will take
appropriate steps to address those liquidity pressures.

 

To that end, today the Bank of Canada, the Bank of England, the
European Central Bank, the Federal Reserve, and the Swiss
National Bank are announcing specific measures.

 

Federal Reserve Actions
The Federal Reserve announced today an expansion of its
securities lending program.  Under this new Term Securities
Lending Facility (TSLF), the Federal Reserve will lend up to
$200 billion of Treasury securities to primary dealers secured
for a term of 28 days (rather than overnight, as in the existing
program) by a pledge of other securities, including federal
agency debt, federal agency residential-mortgage-backed
securities (MBS), and non-agency AAA/Aaa-rated private-label
residential MBS.  The TSLF is intended to promote liquidity in
the financing markets for Treasury and other collateral and thus
to foster the functioning of financial markets more generally.
As is the case with the current securities lending program,
securities will be made available through an auction process.
Auctions will be held on a weekly basis, beginning on March 27,
2008.  The Federal Reserve will consult with primary dealers on
technical design features of the TSLF.

 

In addition, the Federal Open Market Committee has authorized
increases in its existing temporary reciprocal currency
arrangements (swap lines) with the European Central Bank (ECB)
and the Swiss National Bank (SNB).  These arrangements will now
provide dollars in amounts of up to $30 billion and $6 billion
to the ECB and the SNB, respectively, representing increases of
$10 billion and $2 billion.  The FOMC extended the term of these
swap lines through September 30, 2008.

 

The actions announced today supplement the measures announced by
the Federal Reserve on Friday to boost the size of the Term
Auction Facility to $100 billion and to undertake a series of
term repurchase transactions that will cumulate to $100 billion.

**********************************

Insight: Fed May Resort to Other Tools to Fight Credit Crunch>
By Steven K. Beckner
Market News International - The Federal Reserve has by no means
exhausted its armory of tools for combatting the credit crunch, and
further, even more aggressive liquidity-providing measures have not been
ruled out.
There are a number of additional steps which the Fed and its
principal agent the New York Federal Reserve Bank could take, although
some would require the authorization of the Fed's policymaking Federal
Open Market Committee or the Fed's Board of Governors.
With the Fed having just announced on Friday a significant
expansion of its Term Auction Facility loans, as well as enlarged and
extended term repurchase agreements, it may be too soon to expect
further actions.
But as financial turmoil continues and credit constraints threaten
the economy, the Fed is in a state of almost hair-trigger readiness to
consider extraordinary, possibly even unprecedented, measures.
One possibility would be for the FOMC to use authority granted to
it by Congress to direct the New York Fed's open market desk to make
outright purchases of "agencies" -- the securities of "government
sponsored enterprises" (GSEs) such as Fannie Mae and Freddie Mac.
The New York Fed could, with a directive from the FOMC, buy the
agencies' own obligations and/or "agency pass-throughs" -- mortgage
backed securities guaranteed by Fannie and Freddie.
As part of its surprise announcement Friday morning, the Fed
announced it would be doing up to $100 billion in 28-day term, single
tranche repurchase agreements, and a senior Fed staffer indicated that
those repos would likely be slanted toward agencies and MBSs. And since
the New York Fed plans to offset those repos with other operations, the
net result will almost certainly be a reduction in the System Open
Market Account's holdings of Treasury securities relative to agencies
and MBS.
But what the Fed has not done up until now, although it has been
considered, is outright purchases of agencies and agency pass-throughs.
The FOMC's next scheduled meeting is on March 18, but it would not
have to wait that long if Chairman Ben Bernanke decides that such action
is needed. Last week, Bernanke hinted at a willingness to act quickly
and decisively when he said the crisis in the mortgage market calls for
"a vigorous response."
There are other steps that could be taken as well. Among other
things, it could further enlarge both the TAF auctions and the term
repos. Further, coordinated liquidity actions with other central banks,
beyond the reciprocal swaps already announced last December, could be
contemplated.
Or the Fed could "go nuclear" in a sense.
It has the authority to use its discount window -- or for that
matter the TAF -- to lend directly to non-banking companies -- to
securities firms or even commercial enterprises, but only if five
members of the Fed's Board of Governors determine that "unusual and
exigent circumstances" exist in financial markets.
As of now, there are only five sitting members of the Board,
including Gov. Randall Kroszner, so the vote would have to be unanimous.
(Kroszner's term expired at the end of January, but until he is replaced
he continues to sit on the Board with voting rights.)
Lending to non-banks is something the Fed has not done since it was
given that power during the Great Depression, and it is something the
Fed is not eager to do. Officials have said privately that that
particular application of the "lender of last resort" function is one
they would only resort to after other options have been exhausted.
However, the unprecedented may no longer be the unthinkable.
In recent weeks, Fed officials have expressed growing alarm at the
deterioration in financial market conditions. Once highly regarded firms
and municipalities have faced sharply widening credit spreads or have
been cut off from credit entirely as falling home prices have led to
falling securities prices and in turn falling collateral values.
A subdued Vice Chairman Donald Kohn, subjected to the most
withering line of questioning in years by the Senate Banking Committee,
admitted last week, "It looks very shaky -- every day there is some more
bad news." And indeed the size and dispersion of losses among major
banks, investment banks, hedge funds and others has caused some to say
that the United States is experiencing the worst ever seizing up of its
financial markets.
A day before the Fed made its dramatic TAF and repo announcements,
New York Federal Reserve Bank President Timothy Geithner warned the
credit crunch could have "an outsized adverse impact" on the economy and
said the Fed needed to move "proactively."
Geithner's comments were just the latest in a series of remarks by
Fed officials that betrayed a heightened sense of urgency which hinted
strongly not only at the emergency liquidity provisions but also at
additional, aggressive monetary easing -- and an extended period of low
rates.
Earlier, Cleveland Fed President Sandra Pianalto, an FOMC voting
member, said the economy is "highly vulnerable" to a "significant credit
crunch" and said the Fed has to be ready to act in an "aggressive and
timely manner."
In keeping with what Bernanke has called the Fed's need to be
"exceptionally alert and flexible," it has made a series of surprise,
intermeeting announcements -- beginning last Aug. 17 when it disowned
the tightening bias adopted just 10 days earlier and announced a halving
of the "penalty" spread on primary credit loans from the discount
window; on Dec. 12 when it announced creation of the TAF and
reactivation of currency swaps; again on Jan. 22, when the FOMC slashed
the federal funds rate 75 basis points, and most recently last Friday
with the enlargement of TAF auctions and term repos.
No one should be surprised if the Fed makes further "vigorous
responses."

*****************************

 

From the Wall Street Journal-

 

Will Fed Try Something New to Aid Markets?
By DAVID WESSEL
March 11, 2008
With worsening strains in credit markets threatening to deepen and prolong an
incipient recession, analysts are speculating that the Federal Reserve may be
forced to consider more innovative responses -- perhaps buying mortgage-backed
securities directly.
"As credit stresses intensify, the possibility of unconventional policy options
by the Fed has gained considerable interest, said Michael Feroli of J.P. Morgan
Chase.
He said two options are garnering particular attention on Wall Street: direct
Fed lending to financial institutions other than banks and direct Fed purchases
of debt of Fannie Mae and Freddie Mac or mortgage-backed securities guaranteed
by the two shareholder-owned, government-sponsored mortgage companies.
Fed officials have said that, at times like these, the prudent course is to
evaluate all sorts of ideas, many of which may be rejected.
Since 1932, the Fed has had the authority to lend, against collateral, to
individuals, partnerships or corporations other than banks in "unusual and
exigent circumstances," subject to the vote of five members of the Board of
Governors. (The board has seven seats, but two are currently vacant.) This
power has never been used.
Mr. Feroli noted that Congress in 1966 gave the Fed temporary authority, made
permanent in 1979, to purchase obligations of government-sponsored enterprises,
such as Fannie Mae and Freddie Mac.
So far, the Fed hasn't purchased GSE obligations except in its short-term
repurchase operations. When the federal budget was in surplus, the Fed
considered outright purchases of GSE obligations, but judged against such a
move as it would reinforce the perception of an implicit government guarantee.
Last week, the Fed said it would lend banks $100 billion starting this week in
28-day loans through its new Term Auction Facility, at which banks can post a
wide variety of collateral, including mortgages, corporate loans and other
items that have become harder to sell in the open market. And it said it would
make money-market loans of as much as $100 billion to its network of 20 bond
dealers for 28 days, double the usual maximum term, and structure them to
encourage dealers to submit mortgage-backed securities guaranteed by Fannie and
Freddie Mac.
Sen. Christopher Dodd (D., Conn.), chairman of the Senate Banking Committee,
has suggested creating a new government corporation that could buy
mortgage-backed securities.
But direct Fed purchases may be more practical and address current problems
"head on and immediately," David Ader, U.S. government bond strategist at RBS
Greenwich Capital, said in a note to clients.
"Plans like Dodd's or ideas like an explicit guaranty for the agencies are far
more political and will take a while to work out."
"If there is a message in the madness, it's this: The market is looking
elsewhere for a 'solution' to the broad mess that started in housing and will
presumably end with housing albeit with some big victims along the way," Mr.
Ader said. "Meaning someone or something will have to buy mortgage-backed
securities as a starter, to restore liquidity and confidence," he said. "We
emphasize that this is what the market is saying, not that it will happen or
won't."
The Fed's target for the federal funds rate is already down to 3% despite
rising inflation. The yield on two-year Treasury notes is a low 1.4%. And the
yield on five-year notes, Treasury's inflation-protected securities, is
negative, which means that investors accept a return lower than the eventual
rate of inflation. All this suggests the Fed already has its foot heavily on
the monetary gas pedal.
"The Fed has few traditional tools to use and, in the case of an interim ease
or 75 basis point [three-quarter percentage point] cut later this month, it had
better use them sparingly," Mr. Ader said.
Still, Wall Street Fed watchers increasingly anticipate that the Fed will cut
its target for the federal funds rate -- at which banks lending directly to
each other -- to 2.25% from 3% at its March 18 meeting. Fed officials haven't
been convinced that steep a cut is wise.
"The speed and agility with which public policy makers and private financial
institutions respond...will determine how quickly and how smoothly market
conditions return to normal," Timothy Geithner, president of the Federal
Reserve Bank of New York, the epicenter of the current crisis, said last

Today's TIDBITS

March 10, 2008   

From Former Fed Vice-Chairman Alan Blinder:  “The problem is not so much liquidity as the unwillingness of anyone to take any risk…The deeper problems with our financial system are not going to be fixed by injecting more and more liquidity into the markets.”

End-of-Day Market Update

From SunTrust:  “Credit turmoil continues to spread, hitting financial stocks especially hard. Thornburg Mortgage's shares have been halted with the last trade printing at 99 cents. Bear Stearns fell almost 14% on concern the dealer did not have enough liquidity to operate. This was vehemently denied by a company spokesperson, but investors took cover. Citi is lower by 5%, WaMu by 4.5% and Fannie shares are worth 12% less. In response, the 3 month bill has rallied 20 bp to a 1.30 discount. 2 yrs hit a new yield low of 1.42, 5 yrs traded at a new cycle low of 2.32. The 2/10 yield curve has held steady at +199 bp. Volume in coupons has not been huge, but liquidity is poor so it takes less size to move markets. Indirect bidders for a third week in a row took a record amount of bills in the auction. Indirects totalled $17.8 bln of the $46 bln total. This amounts to 47% of the 3 month auction and 35% of the 6 month.”

From Bloomberg:  “Crude oil rose above $108 a barrel in New York to a record… surged 80 percent over the past year as the S&P 500 and Dow averages dropped. China, the second-biggest oil- consuming country, increased crude-oil imports by 18 percent last month and halted overseas shipments to meet rising demand….``The grab for hard assets is on due to the lack of confidence in the rest of the markets at the moment.''  Crude oil for April delivery rose $2.77, or 2.6 percent, to $107.92 a barrel at the 2:30 p.m. … the highest since trading began in 1983.”

From UBS:  “Treasuries drifted lower early in the morning before rallying sharply at 11am upon widespread concerns about Bear Stearn's solvency. The market ended 7-11bps  richer across the board…Treasury volume was only 73% of the 30-day average…Swap spreads tightened during the day, then widened back out on the Bear Stearns speculation. We saw very little flows, and spreads went out about 0.5bp across the board. Agencies also had a quiet day, cheapening to Libor by 1bp in the front end and 3-4bps in the long end…Mortgages went from 16 ticks tighter this morning back out to 5 wider versus Treasuries. We saw very little liquidity, and what were once regarded as small trades are moving the basis 3-4 ticks.”

From RBSGC:  “The market rallied to challenge and surpass the levels of last Friday on what started as a quiet Monday, but saw volume accelerate with a bull flattening bid. The move was sparked by continued stress in financing for firms engaged in the credit asset of choice. Rumors were more afoot than facts, but CDS of certain brokers widened sharply with their equities under severe pressure.  That in turn led to the strong bid in the Tsy market, but, and this is notable, the curve did not respond by steepening. This indicates two things to us. One is that the steepening trade is indeed crowded and without the immediate benefit of a traditional ease in the Funds rate, i.e. inter-meeting, a bit of impatience is at hand. The second is more speculation than empirical fact, but that is that investors how have stayed very neutral throughout the rally want to extend -- certainly balk at 2s near 1.40%.  But the story of Monday is really one of the increasing stress on the credit markets, with the latest incarnation that of financing positions. This, in turn, brings the message right to the door of the banks and brokerages who recognize that there are repercussions as they choose not to finance others -- charging higher rates, deeper haircuts, etc.  We are not making a forecast or revealing something of insight, however it seems that the system is being tested to see who will be the first to 'break', or perhaps more prosaically give itself up for sale or go under. Call it a stress test.   Rumors and speculation to take up a lot of this market's attention. The one we feel has some merit is a Fed response that could, perhaps, amount to an idea similar to that of Sen. Dodd's. That is, changing what they can buy to include MBS, as an example. From our perspective, making a direct foray into the asset class -- where current coupon yields have risen some 50-odd bp since the interim cut in late January -- addresses the problem head on and immediately. Plans like Dodd's or ideas like an explicit guaranty for the agencies are far more political and will take a while to work out.  If there is a message in the madness, it's this; the market is looking elsewhere for a 'solution' to the broad mess that started in housing and will presumably end with housing (albeit with some big victims along the way). Meaning someone or something will have to buy MBS, as a starter, to restore liquidity and confidence. WE EMPHASIZE THAT THIS IS WHAT THE MARKET IS SAYING, not that it will happen or won't. We happen to agree. Our concern is that with Funds already at 3%, 2s at 1.44%, the Fed has few traditional tools to use and, in the case of an interim ease or 75 bp cut later this month, and had better use them sparingly.  Overall volumes were modest, but increasing throughout the session…”

From Lehman:  “Treasuries rallied sharply once again on Monday… The price action of the past three days has all the feel of a wholesale de-leveraging, as accounts are forced

 out of longs and short positions all across the yield curve, but investors seem  to have their hands full at the moment, and so extremes in treasury RV only merit a passing interest.  Monday marked the third consecutive day of big outperformances for the 10 year sector, but we continued to see much better selling in the sector, particularly from international real money accounts.  We also saw better selling of long bonds today, and only saw good buying in the 5 year sector… Despite …the overall better selling that we saw today, the market continued to surge higher, probably in response to the things

that are becoming the norm - softening stock prices, weaker credit, a surge in oil, you know the routine.  For the second straight day, the yield curve flattened hard from 2s to 10s, and steepened from 10s to 15s.”

From Bloomberg:  “U.S. stocks fell for a third day to the lowest level since 2006, led by a plunge in financial shares, on speculation earnings estimates will prove to be too high as the economy slows and credit losses spread.  The decline in banks steepened as Bear Stearns Cos. Tumbled the most since 1987 on concern the brokerage was facing financial difficulties, even after former Chief Executive Officer Alan ``Ace'' Greenberg said the speculation was ``ridiculous.'' Fannie Mae and Freddie Mac, the largest U.S. mortgage finance providers, both lost more than 11 percent on expectations they face increasing losses as the housing slump deepens.  The Standard & Poor's 500 Index declined 20 points, or 1.6 percent, to 1,273.37 and is down almost 19 percent from its Oct. 9 record. The Dow Jones Industrial Average lost 153.54, or 1.3 percent, to 11,740.15. The Nasdaq Composite Index decreased 43.15, or 2 percent, to 2,169.34. Five stocks fell for every one that rose on the New York Stock Exchange… All 10 industry groups in the S&P 500 dropped today on growing concern that the economy will slip into a recession after banks posted $188 billion in subprime-related losses and analysts forecast earnings for members of the index will decline this quarter and next. The benchmark for U.S. equities is approaching a so-called bear market, which is marked by a decline of at least 20 percent from a peak.  Financial shares in the S&P 500 slumped 3.1 percent as a group today to the lowest level since May 2003 and contributed the most to the broader index's retreat. Producers of raw materials slumped 3.3 percent and industrial companies dropped 1.8 percent as a group.  Bear Stearns, the second-biggest underwriter of mortgage- backed bonds, tumbled $7.78, or 11 percent, to $62.30, its steepest drop since October 1987.       ``There's an insolvency rumor and concerns on liquidity, that they just have no cash,''… Fannie Mae fell $2.96, or 13 percent, to $19.81 after Barron's said solvency may be tested at the largest source of financing for U.S. home loans.  Freddie Mac slid $2.26, or almost 12 percent, to $17.39. The company ``could generate a writedown'' of as much as $5

billion should McLean, Virginia-based Freddie Mac be required to mark to market half of its holdings of subprime mortgages and mortgage bonds, Credit Suisse Group analyst Moshe Orenbuch said today in a report to clients.  Financial companies in the S&P 500 have dropped 20 percent this year, dragged down by the collapse of the subprime-mortgage market.”

Three month T-Bill yield fell 11 bp to 1.33%  (2003 low yield was .81%)

Two year T-Note yield fell 2.5 bp to 1.49%  (2003 low yield was 1.084%)

Ten year T-Note yield fell 7 bp to 3.46%  (2003 low yield was 3.114%)

Dow fell 154 to 11,740  

S&P 500 fell 20 to 1273  

Dollar index fell 0.06 to 72.96

Yen at 101.8 per dollar 

Euro at 1.534

Gold fell $1 to $972

Oil rose $2.80 to $107.90  (Record High)

*All prices as of 4:30 PM

**********************

I am attaching the full Barron’s cover story on Fannie Mae below-

“Is Fannie Mae the Next Government Bailout?

By JONATHAN R. LAING

IT'S PERHAPS THE CRUELEST OF ironies that in the U.S. housing market's greatest hour of need, the major entity created during the Depression to bring liquidity to housing, Fannie Mae, may itself soon be in need of bailout.

Fannie, of course, occupies a curious middle ground between the public and private sector as a result of its privatization in 1968 as a Government Sponsored Enterprise, or GSE. While owned by its shareholders, Fannie is regulated by a government agency and is able to borrow money cheaply, thanks to an implicit guarantee by Uncle Sam. It uses those funds to buy and securitize home loans -- lots of them. At year end, the company owned in its portfolio or had packaged and guaranteed some $2.8 trillion of mortgages or 23% of all U.S. residential mortgage debt outstanding.

The company's balance sheet appears larded with iffy assets and understated liabilities.

Of late, however, Fannie's prospects have darkened notably. The company (ticker:

FNM) lost $2.6 billion last year as a surge of red ink in the final two quarters more than wiped out a nicely profitable first half. And by late last week, credit-market jitters had penetrated the once-unassailable hushed precincts of the market in Fannie debt.

In the wake of margin calls on collateral at the investment concern Carlyle Capital, yields on guaranteed mortgage securities issued by Fannie and its GSE sibling Freddie Mac (FRE) rose to their highest level over U.S. Treasuries in 22 years. Likewise credit default swaps, measuring market concerns over the safety of Fannie corporate debt, have ballooned out to 2% of the insured amount from 0.5% just four months ago.

Company executives attribute such concerns to what Fannie CEO Daniel Mudd last month called "the toughest housing and mortgage market in a generation." He also said that much of 2007's loss came from reducing to market levels the value of derivatives that Fannie uses to hedge its interest-rate risk. And those accounting moves should reverse and fatten earnings in the fullness of time once interest rates stop dropping.

But, if the truth be known, a considerable portion of Fannie's losses also came from speculative forays into higher-yielding but riskier mortgage products like subprime, Alt-A (a category between subprime and prime in credit quality) and dicey mortgages requiring monthly payments of interest only or less. For example, Fannie's $314 billion of Alt-A -- often called liar loans because borrowers provide little documentation -- accounted for 31.4% of the company's credit losses while making up just 11.9% of its $2.5 trillion single-family-home credit book. Fannie was clearly looking for love -- and market share -- in some of the wrong places.

Likewise, Barron's has found other areas that may bode ill for Fannie's prospects. Its balance sheet is larded with soft assets and understated liabilities that would leave the company ill-equipped to weather a serious financial crisis. And spiraling mortgage defaults and falling home prices could bring a tsunami of credit losses over the next two years that will severely test Fannie's solvency.

Should Fannie or the similarly hobbled Freddie Mac buckle, the government would no doubt bail them out and honor their debt and mortgage guarantee obligations.

Fannie common and preferred shareholders would likely suffer grievously in such a scenario.

Fannie, for its part, insists it's more than adequately capitalized to withstand any future stress. The company also contends that as a result of tightening its standards and making fewer risky loans, the quality of its book of business will improve mightily.

But some financial leaders aren't so sure. At a conference several weeks back, William Poole, president of the St. Louis Federal Reserve Bank, said that the GSEs (clearly a reference to Fannie and Freddie) appeared to be insufficiently capitalized to handle the kind of losses suffered by U.S. major banks in the past six months. "I do not have any information on the GSEs that the market does not have," he said. "Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious trouble."

And, in commenting on the government's "too big to fail doctrine" for financial institutions, he said: "First, firms in trouble ought not to be bailed out, unless the bailout takes a form that imposes heavy costs on managers and shareholders."

POOLE HAS LONG BEEN skeptical -- correctly it turns out -- of Fannie and Freddie's ability to serve both God (their social mission of promoting liquidity and affordability) and Mammon (the shareholder and lush management compensation). At Fannie, a generation of Democratic Party insiders, such as James Johnson, Jamie Gorelik and Franklin Raines, made substantial fortunes in Fannie's executive suite. As Fannie Mae's top regulator, James Lockhart, pointed out in recent congressional testimony, the absence of debt-market discipline (the government guarantee makes Fannie and Freddie all but impervious to credit downgrades) makes pell-mell growth irresistible to shareholders and managers.

Have a hunch, bet a bunch.

The Bottom Line:

The stock down 65% since last fall, may well fall a lot farther. As capital declines, the company could issue more stock. But that, too, would hurt shareholders.A major scandal erupted at Fannie earlier in the millennium when the company was found to be cooking its books to hide a multibillion-dollar loss it had incurred when massive interest-rate bets went awry. Freddie got nailed at the same time for setting hedging profits aside in a cookie jar to boost results in subsequent years. Yet, the recent lending bets made by Fannie are likely to prove far more damaging.

On the surface, Fannie's balance sheet looks fine. At year end, the company reported regulatory net worth of $45.4 billion, some $3.9 billion higher than the expanded minimum capital of $41.5 billion required by federal regulators.

But with its extreme leverage -- assets stand at 20 times net worth -- Fannie has little room for error. And there appear to be significant problems with the way Fannie has valued both its assets and liabilities.

For example, some $13 billion of its $45.4 billion in net worth consists of deferred tax assets that have value only if Fannie can earn enough money in the near future (say $36 billion) to employ them. That hardly seems likely. During the housing boom of 2002 to 2006, this tax asset only climbed -- from zero to $8 billion as Fannie reported $23 billion in income from 2003 to 2006.

Last year's $2.6 billion loss compounds the problem, pushing the tax asset to

$13 billion. At a minimum, accountants may require the company to sharply write down the value of this asset, thus slashing net worth. Bank regulators, for example, limit the amount of deferred tax assets for regulatory purposes to the lesser of the amount expected to be used within one year or 10% of regulatory capital. So if Fannie were a bank, this entire asset would be wiped out. Fannie maintains the value of the asset will be realized over time.

Another soft asset is Fannie's $8.1 billion of Lower Income Housing Tax Credit partnerships. The partnerships' only value, other than helping fulfill Fannie's housing affordability requirements, are the rich tax credits they generate from their intended operating losses. The problem is that Fannie hasn't made enough money to employ these tax credits. Thus the asset is apt to dwindle away to zero without providing Fannie any benefit. Fannie makes no predictions on the future values.

The story is much the same for the liability side of Fannie's balance sheet.

There's an item called guaranty obligation, which represents the company's best estimate on what it will have to pay out to make good on any mortgage defaults in its $2.4 trillion guaranty book. On its regular balance sheet, Fannie carries the item at $15.4 billion, but on its "fair value" balance sheet, which attempts to mark every asset and liability to current market value, the guaranty obligations are pegged at $20.6 billion. The problem was, as Morgan Stanley analyst Kenneth Posner discovered, Freddie went through the exact same drill with its guaranty obligations' fair value and chose to mark them much more aggressively. It valued them at 1.5% of its guaranteed book, double the 0.74% of total book that Fannie saw fit to use, even though Freddie's delinquency rate is lower than its rival's.

Had Fannie taken a similar hit, its fair-value net worth would've shrunk by some $20 billion to a paltry $16 billion, compared with its juiced-up regulatory capital of $45.4 billion. Fannie stands by its estimate and says it doesn't know how Freddie arrived at its own.

Finally, Fannie seemed to have been inordinately easy on itself when, in the fourth quarter, it wrote down its $74 billion holdings of privately packaged, non-agency subprime and Alt-A mortgage securities by a mere 6%, or $4.6 billion.

In addition, Fannie declared that only $1.4 billion of the write-down constituted a permanent impairment, something that penalized both Fannie's profits and net worth. The remainder of the write-down was deemed a temporary mark-to-market loss that had no such negative impact.

Had Fannie charged off the remaining $3.2 billion that would have torched most of the $3.9 billion in excess regulatory capital that it held at the end of the fourth quarter. Nearly all the major banks, from Merrill Lynch to UBS, have taken much larger percentage write-downs on their holdings of similar mortgage paper, and ran virtually all the losses through their income statements.

In any event, continued deterioration since year end in indexes like the ABX triple-A index indicate that Fannie, based on the different vintages it owns, should conservatively take another $14 billion charge, according to Barron's estimates. Fannie Mae says that since it's a long-term investor, it should incur no permanent decrease in asset value beyond what it has recognized.

The very survival of Fannie as a going concern hinges on the size and speed of the credit losses it faces in the years ahead. Merrill Lynch's Kenneth Bruce sees Fannie suffering losses on its current book of around $32 billion over the next decade. Yet, he still expects the company to manage recovery earnings per share of between $2.50 to $4 between 2009 and 2011.

His forecast, however, is based on spirited 8% average annual growth in Fannie's credit book over the decade. Although Fannie has just been cleared to deal in mortgages of up to $700,000, from $420,000 now, 8% growth could be hard to come by if the company's capital remains stretched.

Pillars in Peril? Problems at Fannie Mae and Freddie Mac can have big implications. The agencies support some 55% of all mortgage originations, after a dip in 2004-2006, and account for half of all outstanding mortgages.

IN OUR VIEW, THE RAPID DECLINE in home prices and soaring level of foreclosures might cause the wave of credit losses to hit far sooner and with greater ferocity than many imagine, potentially submerging the income Fannie is expecting to harvest from volume growth and higher lending fees.

A new phenomenon of widespread negative equity -- homeowners owing more on their mortgage than the underlying property is worth -- has wrought a sea change in borrower behavior. Borrowers, whether subprime or prime, financially stretched or flush with cash, are walking brazenly from their l obligations in stunning numbers.

To be sure, Fannie has a better book of mortgages than most institutions. Fannie requires a layer of credit insurance on much of its high-loan-to-value mortgages. The GSEs have long insisted on higher underwriting standards on the loans they purchase in the secondary market.

Yet using conservative default rates of 40% on its $133 billion subprime book, 12.5% on its $314 billion of Alt-A mortgages and 4% on its remaining $2 trillion of prime home mortgages, Fannie could well be facing cumulative credit losses of over $50 billion. That's after assuming Fannie will realize recoveries of 60% on its subprime and Alt-A loans and 70% on its prime loans. Should Fannie founder over the next couple of years, the government would have no choice but to step in and back all of its debt and guarantee obligations. Too much of the paper is owned by our major creditors, such as China and Japan.

Perhaps, both Fannie and Freddie can go back to the capital markets to raise more equity, as they did last fall when both sold a combined $13 billion of preferred stock. Both have said they may take such action should circumstances demand it. But with both stocks in steep decline -- Fannie's is down 65% since last fall -- offerings would bring punishing dilution and growing investor skepticism.

Just maybe a bailout of Fannie, in effect a nationalization, would be a good thing. A retooled Fannie could pursue its important social mission without the distraction of trying to please Wall Street. Of course, it's doubtful if this happens that the shareholders would be along for the ride.”

Wholesale Sales Rising Faster Than Inventories, as Food and Energy Prices Continue to Rise, Pushing I/S Ratio to Record Low

Wholesale inventories on Friday rose +.8% MoM (consensus +.5%), but as sales rose an even stronger +2.7% MoM (the largest monthly gain in 4 years), causing the inventory to sales figure to drop to a record low of 1.07 months.  Wholesalers account for about a quarter of all business stockpiles.  Rising stockpiles were apparent at machinery, metal, clothing and farm product distributors.  Auto stockpiles at wholesalers fell a large -.7% MoM.  The slowdown in auto sales has businesses being very cautious on growth as the economy slows.

 

Durable goods inventories rose +.6% MoM and non-durable stockpiles rose +1.2% MoM.  Non-durables include energy and food products.  Part of the reason for the stronger rise in non-durable stockpiles was due to higher prices.

 

Over the past year, inventories have risen +6.4% YoY, with a substantial +15% YoY rise in non-durables.  Groceries are up +7.5% YoY.  Sales have risen a much larger +15% YoY, with ex-petroleum sales rising +10% YoY.    Machinery and grocery sales have both risen 10-12% YoY, while petroleum sales have risen +64% YoY.  Most of the energy rise has been due to higher prices rather than volumes.