Retail Sales Sink Without Tax Rebates To Support Spending

Retail sales fell more than expected in August, dropping -0.3% MoM (consensus +0.2%, prior revised down to -0.5% from -0.1%). As retail sales account for about 30% of total consumer spending, which in turn accounts for about 70% of GDP, a slowdown here is bad for the economy. If auto sales are excluded, retail sales fell -0.7% MoM (consensus -0.2%, prior +0.3%), for the largest decline this year. Clearly, the impact of the tax rebate checks has faded fast as wages struggle to keep up with inflation and unemployment rises. Tightening credit is not helping the situation either. The sales declines were broad-based in August. Declines were seen in electronics, building materials, clothing, and even gas station sales (-2.5% MoM). The drop in gasoline prices was apparent. Excluding gasoline, retail sales were unchanged last month after falling -0.6% MoM in July. New incentives helped auto sales rise for the first time since January, growing +1.9% MoM after hitting a 15-year low in July. Department store sales experienced their largest drop in over a year at -1.5% MoM. Sales at non-store retailers (internet) fell an even larger -2.3%, for the largest drop since March 2007. Sales of goods excluding autos, gasoline, and building materials fell -0.2% MoM, the most this year. Back-to-school sales have been relatively weak this year hurting clothing retailers such as Gap and Target. Over the past year, retail sales have fallen -0.4% YoY, with sales excluding gasoline falling -2.8% YoY. Areas seeing the most weakness over the past year include motor vehicles (-17% YoY), furniture and building materials have both fallen -8.3% YoY, and department store sales have slid by -4.4% YoY. Strength has been seen in gasoline stations (+21% YoY), due to higher oil prices, and food (+6.4% YoY), again due to higher prices. General merchandise (+4.6% YoY) and sporting goods (+3.2% YoY) have also improved.

Lower Energy Prices Reduce Headline PPI, But Core Rises to 17-Year High

Lower energy prices (-4.6% MoM, and biggest monthly drop in almost two years) let producer price inflation fall even more than expected in August, and for the first time in 2008. The headline PPI fell -0.9% MoM (consensus -0.5%, prior +1.2%) and eased back to 9.6% YoY from +9.8% in July. The market had looked for a further surge higher to +10.2% YoY. Core PPI, which excludes food and energy costs, came in closer to expectations, helped by falling vehicle prices. Over the past year, core PPI has continued to rise, growing by +3.6% YoY in August versus +3.5% YoY in July. This puts core PPI at the highest level since 1991. On a monthly basis, core PPI rose +.2% MoM, as expected, down from the +0.7% MoM pace of the prior month when oil prices spiked to a new record high. Excluding just energy, prices rose +.2% MoM and +5% YoY. Excluding only food, prices fell -1.2% MoM and rose +9.8% YoY. Consumer goods fell -1.2% MoM in August, but are up 12% YoY. The declines this month were led by natural gas falling -5% MoM and gasoline declining by -3.5%. The largest increase for a major category was in women’s apparel, which rose +.9% MoM. Passenger car prices eased back down, falling -0.3% MoM after rising +1.4% MoM in July. Capital goods prices rose +0.1% MoM (+3.2% YoY). This category includes computers (-1.2% MoM) and light trucks (-1.9% MoM), as well as civilian aircraft (+0.7% MoM). Intermediate goods prices fell for the first time in over six months, easing down by -1% MoM, but are still -17% higher YoY. Excluding food and energy, intermediate prices rose a relatively robust +1.7% MoM, which will remain a concern. Crude goods prices fell an even stronger -12% MoM, but are still up +38% YoY. The large drop in crude goods prices was for energy, which fell -20% MoM, but is still +59% higher YoY. The Fed will appreciate these inflation numbers, which supports their assertion that inflation will moderate as the economy slows. Slowing growth, both in the US and around the world, are helping ease the demand pressures for goods and commodities.

Consumer Confidence Rebounds Nicely on Lower Gasoline Prices

Lower oil prices caused the University of Michigan consumer confidence to leap higher. The market had looked for the preliminary September reading to hold close to the final August reading at a depressed 63. Instead the index soared to 73.1, a full ten point gain. This reading is still above the 85.6 average of last year, but is a clear improvement. Most of the improvement was in the outlook, which rose to 70.9 from 57.9, instead of the current conditions which rose to 76.5 from 71 in August. Also of note, inflation expectations plummeted. One year expectations fell to 3.6% from 4.8% in August. Five year expectations eased to 2.9% from 3.2%. Both have fallen back to their lowest levels since last Feb/March.

Business Inventories Rise in July As Sales slowed to slowest growth since last winter at +0.5% MoM

Slowing sales pushed up business inventories twice as fast as expected in July. Business inventories rose +1.1% MoM (consensus +.5%, prior revised up to +.8% from +.7%). Sales rose at their slowest pace since last February, rising by +.5% MoM in July versus +1.7% MoM in June. The inventory-to-sales ratio rose marginally to 1.24 from 1.23, but remains very low historically. Over the past year, business inventories have risen +6.4% YoY while sales have risen an even faster +10.6% YoY.

The slowdown in sales and rise in inventories will probably cause businesses to slow growth in order to keep stockpiles lean as the economy weakens. The 1.1% increase in the value of unsold goods was the largest in four years.

Auto inventories lead the inventory gains in July, rising by +3.2% MoM (+0.8% YoY). This was the largest monthly gain in auto inventories in more than two years. Remember that auto sales hit a 15-year low this summer, so much of this increase was probably unintended, or tied to the parts strike that ended in July. Excluding autos, retail inventories rose +.8% MoM (+2.3% YoY). Stockpiles at furniture stores also rose a strong +1.3% MoM, as sales fell -.2% MoM.

Among the three major categories, retail inventories, which accounts for about a third of the total, rose +1.5% MoM (+1.8% YoY), followed by wholesale inventories (29% of total) rising by +1.4% MoM (+10.6% YoY), while manufacturing inventories (37% of total) grew much more slowly in July at +0.5% MoM (+7.6% YoY).

Among the three major categories, manufacturing sales rose +2.1% MoM (+8.8% YoY), while wholesalers and retail firms saw sales drop. Slower consumer spending caused retail sales to fall -0.6% MoM (+1.9% YoY), sales at wholesalers fell -0.3% MoM (+16.5% YoY).

Inventories versus sales remain highest at retailers, at 1.48, and lowest at wholesalers at 1.07. Businesses have done an exceptionally good job keeping inventories lean this year, which means there are no large inventory overhangs to work through.

In the second quarter, companies trimmed inventories by almost $50B, the biggest drop in over six years since the last recession. This subtracted almost 1.5% from GDP growth. Rising inventories are likely to boost GDP growth in the third quarter, which is unlikely to persist as companies remain very proactive in containing undesired inventory accumulation. It is important to remember that part of the gain in inventories is due to higher prices.

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

Import and Export Prices Both Have Largest Monthly Declines in 20 Years

Import prices fell for the first time this year in August, falling a much larger than expected -3.7% MoM (consensus -1.8%, prior revised from +1.7% to only +0.2% MoM). In addition, the annual gain plunged from a 27-year high last month of 21.6%, as originally reported ( now revised down to +20.1% YoY), to +16% YoY in August. In fact, the drop in import prices for August was the largest in almost 20 years. Lower energy prices were primarily responsible for the decline. Excluding petroleum, which fell -12% MoM but remains up 52% YoY, import prices fell a more modest -.3% MoM, and are up half the headline rate at +7.5% YoY. So clearly, petroleum prices have been a major driver of the recent volatility in import prices. In fact, imported petroleum prices fell the most in over 5 years in August. Natural gas prices also fell a large -16.4% MoM, the largest monthly drop in almost 2 years. Other major factors pushing up import prices over the past year have been industrial supplies (-8.4% MoM, +39% YoY) and food (+0.7% MoM, +16% YoY). Capital and consumer goods price rises have been very tame. Capital goods import prices in August fell -0.1% MoM and are up only +1.6% YoY. Consumer goods prices were unchanged in August vs July, but have risen +3.1% YoY. Reflecting the types of goods purchased, Canada, a major energy supplier to the US saw prices fall -3.8% MoM, but remain +21% higher YoY. Japan and China, with more consumer goods to the US, have also exported less inflation. Import prices for Japanese goods to the US fell -.1% moM and are up only +1.8% YoY. China is no longer an exporter of deflation, even when energy prices drop. Chinese import prices rose +0.1% MoM and are up +4.9% YoY. This is the first look at August inflation rates, and the news is clearly good with energy prices dropping. This will ease the Fed’s concerns about inflation expectations rising, and allow them to focus more on the poor economic growth both in the US and abroad. The strengthening dollar will also help on the inflation front as foreign goods will become relatively less expensive, but the negative impact of slowing export growth will remain a negative for economic growth as the US consumer shows increasing interest in saving rather than spending as jobs are lost. On the export price side, there was also a large drop. Export prices fell -1.7% MoM, the largest monthly decline since records began in 1988. The drop was due to a -9.6% MoM decline in agricultural export prices. Non-farm prices fell -0.7% MoM. Over the past year, US export prices have risen +8.2% YoY, with food prices rising +25% YoY.

Trade Gap Widens in July Due to Higher Oil Prices

The July trade deficit widened more than expected, after narrowing the past few months, to the largest monthly deficit in 16 months. Higher oil prices, which peaked close to $150 in July, are primarily responsible for the worsening deficit, which grew by $62.2B (consensus -$58B, prior revised up to -$58.8B from -$56.8B originally reported). Higher oil prices offset increased exports of autos, aircraft and machinery in July, as export growth rose by +3.3% MoM. Imports rose +3.9% MoM, but if oil is excluded, the deficit actually shrank last month to the lowest level since 2002. After adjusting for inflation, the trade deficit grew $1.1 B versus June. A shrinking trade deficit was a major boost to GDP growth last quarter. Excluding trade, the economy would have only grown +0.2% in the 2nd quarter. The recent rebound in the dollar as overseas economies weaken may limit further improvement in the trade deficit. The dollar has rebounded 13% since hitting a low in March. The trade gaps with OPEC, Europe, Asia, and Africa all widened in July versus June, with the deficit to OPEC leaping 34% to a new record high of over $24B on higher oil prices. Clearly, the recent sharp declines in energy prices over the past month will help reduce this OPEC oil deficit in August and September. Both goods and services exports rose in July on broad-based strength. Goods services rose +3.9% MoM (+24% YoY), lead by demand for capital goods (+2.2% MoM, +8.6% YoY) tied to computers (+6.9% MoM, +12% YoY) and aircraft (+5.7% MoM, -16% YoY). Consumer goods exports rose +5.3% MoM (+21% YoY) and autos rose +13% MoM (+12% YoY). Demand for services rose a more modest +1.8% MoM (+12% YoY). Imports of goods rose +4.3% MoM (+18% YoY) and services increased by +1.7% MoM (+8.4% YoY). Reflecting higher prices and volumes, crude oil imports rose +19% MoM (-110% YoY), and industrial supply imports grew by +9.6% MoM and +50% YoY. But in July, imported pharmaceuticals fell -16% MoM (+10% YoY) and apparel imports fell by -1.3% MoM (-5.3% YoY).

Continuing Claims Jump 125k to a New 5-Year High

Initial jobless claims held steady at 445k, versus the prior weeks revised higher level of 451k from 444k. The less volatile 4-week moving average held steady at 440k. This compares to a year-to-date average of 380k, and a 2007 average of 321k. Continuing claims continued to climb, as expected, but rose more than anticipated to 3.525M, from a revised lower level of 3.403M. So, a net increase of around 125k in one week to a new 5-year high. The unemployment rate for those eligible for jobless benefits rose to 2.6%, from 2.5% the prior week, as the economy continues to shed jobs.

Lower Interest Rates Cause Mortgage Applications to Rebound

A large drop in mortgage rates last week, to the lowest levels since May, helped lift mortgage applications by +9.5% week-over-week (WoW) last week, according to data from the Mortgage Bankers Association released this morning. Purchase applications rose 6.4% WoW and demand to refinance surged +15.4% WoW. This pushed the refinace share of applications up to 36.3% from 34% the prior week. Thirty-year mortgage rates fell 33bp last week to 6.06% from 6.39% the prior week. Fifteen-year mortgage rates fell 23bp to 5.73%, and one year ARM rates fell 11bp to 7%. In July, the one-year ARM rate reached a seven-year high of 7.25%. ARMs as a percent of total loan applications fell to 6.4% last week. Over the past year, total mortgage applications have fallen -24.4% YoY, with purchase demand falling -16.8% YoY and refinanciing demand plummeting by -34.8% YoY. Demand for fixed rate loans has fallen by -18.5% YoY while demand for ARMs has tumbled by -63.6% YoY.

Today's Tidbits

Non-Bank Lending Down 60% YoY Since Credit Crunch Began a Year Ago

From CFO: “The credit crunch continues to severely hamper corporations' ability to raise capital. The latest evidence: the dollar volume of new-issue fixed income products fell off more than 60 percent in August versus a year ago, according to a report from Lehman Brothers…. That made it the worst August for new-issue fixed income products since 2002…August's volume was down 32.6 percent from July's $379.3 billion. Lehman noted that August is historically down only around 13 percent from July. ..The U.S. dollar volume was off 77.3 percent from last August. Looking at specific asset classes, investment-grade bonds decreased 69.8 percent year-over-year, high-yield bonds 78.3 percent, syndicated bank loans 84.6 percent, asset-backed securities 78.7 percent, residential mortgage-backed securities 95.2 percent, and commercial MBS 100 percent. The only relative bright spot in the fixed-income market was municipals, which increased 4 percent. In Europe, new-issue dollar volume for August decreased a total of only 24.2 percent, because investment-grade bonds shot up 102.2 percent. However, high-yield bonds decreased 68.6 percent, syndicated bank loans 35.6 percent, ABS 84.8 percent, RMBS 50.1 percent, and CMBS 100 percent. Sovereign bonds decreased 28.9 percent in August, helped by the generally higher-quality nature of that marketplace, Lehman explained.”

More Bank Consolidation Likely as Capital Erodes

From Citi: “Consolidation in the US financial system? As we noted yesterday the terms of the settlement for shareholders in the two GSE's (i.e. they lose out) also raises questions about the capital base of many of these shareholders - the smaller regional US banks. In the wake of the 1980’s savings and loans crisis there was a wave of consolidation in the US banking system which saw M&A peak in 1986/87 but failures not peak until 1988/89. From then on there was a major concentration in the banking industry with the share of the top 25 institutions rising to c53% in 1997 from 33% in 1985. This trend was boosted by deregulation. Less regulation does not seem to be part of the current policy response. On the other hand this solution to the GSE’s situation does add to question marks over the capital adequacy of many smaller banks. Their situation will be exacerbated the longer the underlying fundamental housing problem persists. Over the next couple of months many US financials will be reporting earnings so there’s scope for disappointment as well as for news of further failures and mergers. None of this is likely to have much sway on monetary policy as the Fed feels current problems are indeed mainly balance sheet issues rather than the level of interest rates. Monetary policy will continue to be dominated by the outlook for inflation.”

From RBSGC: “S&P places Lehman on Watch Negative -- citing decline in share prices as problematic for raising additional capital. Shares dipped as low as $7.75/share intra-day vs. a $12.92/share open.”

Declining Oil Production in Mexico is Bad for Mexico and US

From Pipeline and Gas Journal : “At 1.5 million barrels per day (bpd), oil from Mexico comprises about 11% of U.S. imports. As a top-three supplier to the U.S., Mexico has been a consistent and reliable source of oil for years. In the first half of this decade, that role increased even further as growing U.S. demand was met with rising Mexican production. Since 2005, however, it has been increasingly apparent that Mexico’s largest oil field - Cantarell - is in irreversible decline. Cantarell accounts for 26% of Mexico’s proven reserves and provides more than half of the nation’s oil output. But the field peaked in 2005 at 2.1 million bpd and by 2008 has fallen to only 1.46 million bpd - a decline of 31%. Further, the U.S. Energy Information Administration (EIA) has suggested Cantarell will likely average an annual decline rate of 14% through 2015. And even that may be an underestimate. An upstream industry magazine recently reported that Mexico’s oil production dropped over 400,000 bpd in the first quarter of 2008 alone. Additionally, estimated production in April is down 12% from March levels. The implications of Cantarell’s decline are far reaching for both the U.S. and Mexico. For the U.S., less oil supply from Mexico means increased reliance on more distant and potentially unstable sources. For Mexico, any drop-off in oil exports could have reverberating socioeconomic and political impacts, as many social welfare programs are funded by oil revenues. In 2006, for example, of the $97 billion in sales by the state-owned Petroleos Mexicanos (Pemex), $79 billion went to the Mexican government. This energy revenue windfall accounted for about 40% of the national budget… Given the broad social, economic and political ramifications of declining oil production, it is difficult to fault government officials who hope for the best. Mexico has: (1) used its oil reserves as collateral for loans, (2) employed its oil profits to fund social programs, and (3) spent much of its increased wealth to develop a growing middle class with rising expectations. The grim reality of oil production decline, and the concomitant erosion of oil revenues, will take some time to filter through Mexico’s national mindset.”
Note – Mexico is currently the third largest foreign supplier of oil imports to the US, and may stop exporting totally by 2012.

India and South America Show Strongest Employment Growth Prospects

From Barclays: “Manpower's global employment outlook survey for Q4 reveals a further moderation in hiring activity, with 25 out of 33 countries reporting a slower pace of hiring versus a quarter ago. The weakest hiring intentions were reported by employers in Spain, Ireland and Italy, which were the only countries expecting negative hiring expectations for the quarter ahead. Conversely, the most favourable fourth-quarter hiring plans globally are reported by employers in India, Costa Rica, Peru, Singapore, Taiwan, Colombia, Romania, Poland, Argentina, Australia and South Africa…In the US, the seasonally adjusted net employment outlook balance fell to +9 in Q4, the weakest since 2004, from +12 in Q3 and +14 in Q2. Across regions, employers in the West and the Northeast have the most favourable hiring outlook, while Midwest employers are most pessimistic. Sectorally, employers in the construction sector remain the most pessimistic, while mining companies are the most optimistic.”

MISC

From Citi: “Total agency MBS issuance fell by 3% in August and is down 39% from May, which was the highest issuance month of 2008. Conventional issuance fell by 10% in July while Ginnie Mae issuance rose by 11%. Ginnie Mae issuance was over 35% of total agency MBS issuance, the highest percentage since July 1997. Issuance should bottom slightly below August levels in September before beginning to climb given the 50bp drop in mortgage rates since mid August. Fannie Mae and Freddie Mac are likely to reduce guarantee fees in the near future based upon comments from the Treasury and FHFA which would further support lower mortgage rates and higher future issuance.”

From Lehman: “The more I look at the Treasury [GSE] plan, the more it looks like a nice way to stop the downside risk of a mortgage market meltdown, but not a way to jump start the economy… the effect is to avoid disaster, not spur growth.”

From RBSGC: “In contemplating the broader implications of the GSE conservatorship, we note that this administration has now done everything it can to support the troubled housing market -- and the structure of the deal buys enough time to make it through the election and into next year, but falls short of a permanent remedy to the GSE's troubles -- policy options are running out.”

From Merrill Lynch: “The announcement of explicit US government support for both Fannie Mae and Freddie Mac has produced both a rally in risk sensitive assets/currencies and short-lived pressure on the USD. Our initial call is that the government intervention carries with it short-term USD positives but longer-term risks, while the moves do little address the broader macroeconomic risks currently troubling markets.”

From CITI: “What a difference a day makes. After yesterday's "euphoria" over the bailout of the two US mortgage GSE's, overnight the realisation that this deals mainly with the symptom rather than the causes of the problem has come to dominate sentiment. This leaves markets to focus on the likelihood that US (and world) growth remains subdued and that central banks will continue to focus on upside inflation risks.”

From MNI: “The US government's decision to take control of Fannie Mae and Freddie Mac has caused widespread relief across Asia, but China is likely to stick to its decision to restrict substantial offshore investment until solid signs of economic recovery emerge, Moody's Economy.com said.”

From JPMorgan: “The most direct way in which the government’s action should affect the economy is through lower mortgage rates at origination, which should spur home sales, thereby reducing inventories of unsold homes. There are possibly other, indirect, effects, such as stabilizing the financial system which could forestall some of the adverse feedback dynamics that have been developing between the economy and financial system.… When looked at using various specifications of home sales models, the estimated response gravitates to a 10% increase in home sales following a 100bp decline in mortgage rates. We mention 100bp not only because it is a round number, but also because this is roughly the decline in mortgage rates that our fixed-income team believes will be experienced by final borrowers relative to the peak reached a few weeks ago. A 10% increase in home sales would pale next to the 35% decline in total home sales experienced in the housing downturn, however, if realized, it would be helpful in contributing to the normalization of housing inventories.”

From UBS: “…in its update on the budget, the Congressional Budget Office revised its baseline budget deficit estimate for 2008 to $407B from the $357B projected in January, with the increase reflecting higher outlays. The CBO also increased its 2009 deficit estimate to $438B from $342B. It should be noted, however, that these deficit projections do NOT take into account the costs of the GSE actions from this past weekend.”

From RBSGC: “The TIPP Economic Optimism index hit the highest since Oct '07 -- a strong correlation with the major consumer sentiment surveys and a clear reflection of the pull-back in gasoline prices.”

From Nomura: “Once again, the sales results from the two weekly surveys of large retail stores were somewhat mixed. The ICSC index fell 0.1% and the 52-week growth slowed to 1.9%, a 12-week low. Owing to strong sales over Labor Day weekend, the Redbook index … 0.8% drop from the August index in the first week was a bit ahead of target. Sales fell off sharply after the holiday but the ICSC report noted that colder and wetter than normal weather in September, which has been forecast for this month, has been associated with relatively strong sales. Further declines in gasoline prices should also help get sales back on a stronger trajectory.”

From BMO: “Japanese machine tool orders fell 14.2% y/y in August, the sharpest decline since
2002.”

From Bloomberg: “Wells Fargo & Co., the California lender that skirted the subprime collapse, topped Citigroup Inc. by market value to become the third-most valuable U.S. bank.”

End-of-Day Market Update

From SunTrust: “Yesterday's euphoric reaction to the bail-out of Fannie/Freddie is fading somewhat. The bulk of the progress made in shrinking agency spreads is still intact, but about 5 bp of widening has occurred today. Ditto for MBS spreads, wider by about 5 bps. Financial shares are also seeing reversals. Both Wells Fargo and Sovereign Bancorp have announced impairment charges will be taken in Q3 related to Fannie/Freddie preferred stock holdings. Lehman, now down 36% on news that talks between the company and KDB have ended, has announced it may release Q3 results as early as today to assuage investors. There is nary a profit-taker for Treasuries, however. The long end of the market is on fire. 10 yr notes are bid at 103-16, up 23 ticks. The bond is higher by 52 ticks at 105-31 (4.18), close to a record low yield. The huge narrowing of agency/MBS spreads yesterday has unleashed a massive amount of convexity buying in Treasuries. Some models estimate that a 50 bp drop in mortgage rates would translate into as much as $200 bln 10 yr equivalents needed in 10 yr notes. This represents much pain for shorts.”

From UBS: “Treasuries rallied 7-8bps across the board today as the market realized that the initial euphoria over the GSE bailout was overdone. While this government takeover may help solve some problems, the wipeout in GSE preferred stock would cause other problems by further depleting capital at some banks. US Bancorp warned that bad loans and impairment from GSE preferreds would lead to Q3 charge-offs of 25% to 28% (Informa reported this). There were other headlines like this and stocks fell hard again (-280 Dow pts) for the biggest drop since February. Lehman Bros. lost as much as 46% intraday (on huge volume) after reports that its talks with KDB have ended without a deal in place. Further jeopardizing Lehman's situation, S&P placed Lehman's 'A' senior debt rating on review for downgrade, potentially forcing the firm to pony up billions more in collateral according to some. Meanwhile, crude oil continued its fall after the oil ministers from Saudi Arabia and Venezuela indicated that OPEC will vote to maintain output. With crude as low as $101.85/barrel earlier this afternoon, TIPS took another severe hammering, and front-end breakevens narrowed by double-digit basis points. Today's volume was a robust 147% of the 30-day average… Swaps saw steepener trades, and spreads widened across the board, especially in the front end. Agencies witnessed very little flow, underperforming Libor by 1-2bps on the day. Fannie Mae announced a new 2-year issue, with the size and pricing to be determined tomorrow. Meanwhile, yesterday's record-setting MBS tightening was followed by an historic widening, with mortgages underperforming Treasuries by 25-30 ticks and swaps by 21-26 ticks. The higher dollar prices from yesterday's move brought in origination, as well as selling by banks and foreign accounts. Today has been one of the heaviest MBS trading days of the year.”

From RBSGC: “The Treasury market put in another impressive performance as yields pushed lower with 2s testing 2.175% and 10s dipping below 3.60% -- back squarely into the pre-NFP range. Domestic equities were under pressure -- with the S&P down more than 2.5%. The fundamental drivers were more flight-to-quality than data skews, as troubles in the financial sector were led by S&P's placement of Lehman's credit ratings on Watch Negative. There were other negative headlines from the sector, and with next week's set of earnings including Lehman, Goldman, and Morgan Stanley -- there remains a heightened sense that the GSE bailout came too late to prevent another round of losses/writedowns. Flows also played a key role in Tuesday's price action, with convexity-related hedging demand for duration at play, as were rate-lock unwinds associated with a series of corporate deals. While the corporate calendar was limited to $3-$4 bn of new deals, the potential for more issuance later in the week is undoubtedly going to be a factor. Position surveys reflect a market caught somewhat offsides by this week's sharp rally in Treasuries -- with the JPM weekly release showing investors the shortest in more than a month -- but flats dominate the responses at 76%... Tuesday's volumes were very strong…”

From Bloomberg: “Crude oil fell to a five-month low, leading commodities lower, after Saudi Arabia's oil minister said supplies are sufficient to meet demand. Orange juice slumped to the lowest in three years. The S&P GSCI index of 24 commodities fell as much as 2.4 percent as gasoline, gold and wheat dropped… Lower costs for raw materials may signal slowing inflation… Agricultural commodities and metals dropped on speculation a worsening global-growth outlook will lead to reduced demand for raw materials.”

From MSNBC: “Stocks ended down sharply Tuesday after fresh worries about the stability of Lehman Brothers Holdings Inc. touched off renewed jitters about the overall financial sector. The Dow Jones industrials fell 279 points. Bond prices jumped as investors sought the safety of government debt. Wall Street’s pullback comes a day after the biggest single-session rally in a month in the Dow so some retrenchment might have been expected. But it was worries about Lehman that punctured a sense of optimism about the financials. Investors had been optimistic about the sector after the Treasury Department announced Sunday it would seize control of mortgage lenders Fannie Mae and Freddie Mac to stabilize the companies. Lehman fell $5.15, or 36 percent, to $9 as investors worried that the No. 4 U.S. investment bank is having trouble finding fresh sources of capital. Investors grew worried that a possible investment from South Korea’s government owned Korea Development Bank remained in doubt. The two sides are said to have called off talks, according to media reports… In midafternoon trading, the Dow fell 279.68, or 2.43 percent, to 11,231.06. Broader indexes also fell. The Standard & Poor’s 500 index declined 43.25, or 3.41 percent, to 1,224.54 and the Nasdaq composite index fell 59.95, or 2.64 percent, to 2,209.81. The declines ate into returns logged Monday when the Dow jumped 2.6 percent, the S&P 500 rose 2.1 percent and the technology-heavy Nasdaq composite index added 0.62 percent… The market’s decline comes a day after investors greeted the government’s plan to take over Fannie Mae and Freddie Mac with a burst of enthusiasm. Investors had been worried that the companies, which hold or back about half the nation’s mortgage debt, would succumb to a spike in bad loans. Fannie Mae rose 34 cents, or 47 percent, to $1.07, while Freddie Mac rose 10 cents, or 10 percent, to 98 cents. Among financial names, Citigroup Inc. fell 85 cents, or 4.2 percent, to $19.47, while Morgan Stanley fell $2.05, or 4.8 percent, to $41.22. Merrill Lynch & Co. declined $1.99, or 7.2 percent, to $25.60. Energy names also lost ground as oil fell. ConocoPhillips fell $2.77, or 3.7 percent, to $71.92 and Schlumberger Ltd. slid $3.06, or 3.6 percent, to $82.95. In corporate news, McDonald’s Corp. said its same-store sales, or sales at stores open at least 13 months, rose 4.5 percent in the U.S. in August and 8.5 percent globally. Shares rose $1.21, or 2 percent, to $63.61.
The Russell 2000 index of smaller companies fell 11.44, or 1.56 percent, to 721.42. Declining issues outnumbered advancers by about 4 to 1 on the New York Stock Exchange, where volume came to 957.1 million shares.”

Prices as of 4:30
Three month T-Bill yield fell 6 bp at 1.65%
Two year T-Note yield fell 9 bp to 2.21%
Ten year T-Note yield fell 8.5 bp to 3.59%
30-year FNMA current coupon fell 4 bp to 5.18%
Dow fell 280 points to 11,231
S&P fell 43 points to 1225
Dollar index fell .08 points to 79.51
Yen at 106.9
Euro at 1.411
Gold fell $26 to $776.50
Oil fell $4.40 to $102

Pending Home Sales Fall in July

Pending home sales fell a larger than expected -3.2% MoM in July (consensus -1.5%, prior revised up to +5.8% from +5.3%). Pending home sales tend to precede existing home sales by 1-2 months, and represents previously owned houses under signed sales contracts, but which have not yet closed. For this reason, pending home sales are viewed as a leading indicator for the housing market. Sales in the Northeast fell by -7.5% MoM and fell an even larger -10.6% MoM in the West. The South saw no change in pending home sales in July, and the Midwest experienced an increase of +2.8% MoM. Over the past year, pending home sales have fallen -6.5% nationally. Both the Northeast and the South have seen a decline of -13.1% from a year ago, while the Midwest is down -3.1% YoY. The West continues to be the strongest region over the past year, with pending home sales rising +9.2% YoY. Part of the strength in the West is due to the large number of foreclosed homes being sold. Many foreclosed homes in Florida are still mired in the court system. There continues to be a large excess supply of homes on the market, and prices remain under pressure due to the rising number of foreclosures.

Wholesale Inventories Rise More Than Expected as Sales Drop for First Time in Over 6 Months

Wholesale inventories, which account for about 25% of all business inventories, rose more than expected in July at +1.4% MoM (+10.6% YoY). Consensus had looked for only half the gain (+.7% MoM). A bright spot is that June’s wholesale inventory growth was revised down to +.9% from +1.1% previously. Durable goods inventories rose +1.6% MoM in July, the largest increase in over two years, while non-durables, which include food and energy, rose a slower +1.1% MoM. Inventories excluding petroleum rose +1.4% MoM and are up +9.9% YoY. The value of petroleum inventories rose +2.8% MoM in July, which was the peak in oil prices. Sales fell -.3% MoM, the first decline since February. This helped push the inventory to sales ratio up slightly to 1.07, but it still remains near its record low of 1.06 set last month. A year ago, the ratio was at 1.13. So, inventories may have gotten a little too lean earlier this year, but firms will be hesitant to let them rise too much in the current environment. All major categories of inventories rose in July, with autos rising +2.3% MoM (+13.5% YoY), and machinery rising +2.7% MoM (+9% YoY). This was the largest monthly increase in machinery in over ten years, and coincided with a 3.7% MoM drop in machinery sales, the largest monthly decline since the recession of 2001. The rise in wholesale auto inventories is understandable as sales reached a 15 year low in July. The rise in machinery inventories may indicate reduced demand due to slowing overseas growth and a strengthening dollar. The only categories to see a decline inventories in July were professional equipment, such as computers, and clothing. An increase in inventories will boost 3rd quarter GDP, but reduces growth prospects for the fourth quarter if they can’t be sold. Falling inventories subtracted -1.4% from 2nd quarter GDP growth.

End-of-Day Market Update

From Merrill Lynch: "When all was said and done, the Tsy rates were unchanged...Does the market realize that the Secondary MBS rate at 5.12% in near the all-time low..." From JPMorgan: "Interestingly, we have entered a new era where the government will target the mortgage rate directly for policy, rather than just short rates. This comes after a long period of rate cuts which had had very little impact on mortgage rates." From Credit Suisse: "The mortgage market was failing because of the fear that insolvent GSEs would become massive net sellers. The Treasury’s GSE bailout fixes this problem."

From LEHC: "The Treasury noted that “(b)ecause the GSEs are in conservatorship, they will no longer be managed with a strategy to maximize common shareholder returns, a strategy which historically encouraged risk-taking.” On the face of it, this statement might suggest to folks that the GSEs will be managed in a fashion where they take less risk. However, Treasury also noted that “the primary mission of these enterprises now will be to proactively work to increase the availability of mortgage finance, including by examining the guaranty fee structure with an eye toward mortgage affordability.” The latter statement suggests that the “new” management may be encouraged to “roll back” some of the GSEs’ recent increases in guaranty fees. Most folks, though, note that it would be really strange public policy if the government placed the GSEs into conservatorship because of safety and soundness issues directly related to a deterioration in the credit conditions of the mortgage market, continuing declines in home prices, and “alarming high” levels of mortgage delinquencies, and then had the companies take on more mortgage credit risk via loosened underwriting guidelines!"

From Bloomberg: "Washington Mutual Inc., the biggest U.S. savings and loan, tumbled as much as 24 percent after ousting Chief Executive Officer Kerry Killinger and disclosing that regulators stepped up scrutiny of the lender's operations. WaMu signed an accord with the Office of Thrift Supervision that calls for the Seattle-based company to reduce risks and overhaul procedures, according to a statement today. Alan Fishman, 62, of Meridian Capital Group, a New York-based commercial mortgage broker, replaces Killinger, 59, who was CEO for 18 years."

From Citi: "Flows seemed unaffected today by the government takeover of Fannie and Freddie. ABCP spreads remained the same, with more and more issuers focusing on issuing paper in to 2009. The best ABCP names continue to trade at libor flat to plus 5 across the curve. Top tier corporate names, such as Johnson and Johnson, continue to trade as far as three months out at Fed funds type levels, but they are no longer 25 to 50 bps through discos, but rather back to roughly flat. Not much premium has been placed on quarter end as of yet, but the libor curve is still exceedingly steep from one to two months(20bps)which doesn't really make much sense..."

From Bloomberg: "U.S. fixed mortgage rates dropped about a quarter of a percentage point this morning after Treasury Secretary Henry Paulson announced the federal takeover of Fannie Mae and Freddie Mac. It may be the beginning of a trend...The average U.S. rate for a 30-year fixed mortgage is 6.08 percent today, down from 6.26 percent last week, according to Bankrate Inc...The federal bailout of the mortgage giants may temper the slide in home prices, Pacific Investment Management Co.'s Bill Gross said in an interview today...It is not without risk, though. ``If the government needs to borrow so much money for the bailout that Treasury yields start to rise, they could begin to compete with mortgages and have the opposite effect,'' Shaugnessy said. ``I think the plan will work, but if it doesn't we'll see rates going up.''

From Bloomberg: " U.S. stocks climbed, adding to a rally across Europe and Asia, on speculation the government takeover of Fannie Mae and Freddie Mac will stabilize the global financial system battered by $507 billion in credit losses. Citigroup Inc., Wachovia Corp. and Bank of America Corp. added at least 6.6 percent after Treasury Secretary Henry Paulson said the government will provide short-term funding to mortgage lenders Fannie and Freddie. KB Home and D.R. Horton Inc. jumped more than 12 percent, sending a gauge of homebuilders to a four- month high. A rally in banks from Germany to Japan sent the MSCI World Index up 2.1 percent, the most since April. The Standard & Poor's 500 Index gained 25.48 points, or 2.1 percent, to 1,267.79, its steepest advance since Aug. 8. The Dow Jones Industrial Average rose 289.78, or 2.6 percent, to 11,510.74. The Nasdaq Composite Index increased 13.88 to 2,269.76. Almost three stocks climbed for each that fell on the New York Stock Exchange... All but one of the 30 companies in the Dow advanced. About 1.7 billion shares changed hands on the NYSE in the busiest trading session since July 23. Treasury 10-year notes gained amid speculation the seizure of Fannie and Freddie won't reverse a U.S. economic slowdown. The dollar increased to the highest in almost a year against the euro. The rally pared the S&P 500's decline this year to less than 14 percent as the index heads for its first annual loss since 2002...The S&P 500 Financials Index rallied 4.6 percent, postingits best gain since Aug. 5 and reaching its highest level since June 19. The rally in banks came even as Oppenheimer & Co. analyst Meredith Whitney slashed her third-quarter earnings estimates for Goldman, Lehman Brothers Holdings Inc., and Merrill, citing a decline in trading volume and share sales."

From Lehman: "How many times have we seen this movie before? First, there is some "good news" released which is on the surface bearish for treasuries, and the market gets plastered. But then the market turns around and rallies sharply, sucking in newly set shorts in the process. Treasuries sold off pretty hard after the close on Friday when the first headlines about a Treasury plan for the GSE’s hit the tapes. While news tidbits around the plan surfaced Friday night and Saturday, the Treasury announcement itself came on Sunday, and it looked both aggressive and comprehensive. (I assume that you have seen the details of the plan ad infinitum by this point, so I won’t waste your time with them here.) Treasuries plunged at the Tokyo open, with 5 year yields rising by another 20 basis points on the top of the 10 bp selloff that came after the 3 PM close Friday. (Mortgages, of course, were doing considerably better, and by day’s end were on the order of 50 basis points tighter to treasuries.) Five year yields got as high as 3.20%, but started to grind lower around the London open, and prices arced higher for the next 12 hours, eventually getting back to 2.95%, or 5 basis points LOWER than where they went out Friday afternoon. Go figure. Volumes were high today...The yield curve flattened today, and the five year sector was a huge underperformer overnight, cheapening by almost 5 basis points to 2s and 10s on the move lower. That move came after a 5 bp richening last week. The sector did recover along with the market but still finished between 2.5 and 3 bp cheaper on the day."

From UBS: "After this weekend's GSE bailout headlines, Treasuries traded dramatically cheaper during the early pre-dawn hours, with front end yields more than 25bps higher versus Friday's close. As the day wore on, however, Treasuries gradually recouped their losses, likely on the back of convexity buying resulting from the mortgage basis' large move. We saw 2-way flow on curve trades (2s5s and 5s30s in particular), along with fast money selling in the 2-year sector. TIPS breakevens finished 2-5bps wider across the board, but were much wider earlier in the day before nominals recovered. Today's volume was 172% of the 30-day average, and the highest level in nearly six months. Equities celebrated the GSE announcement, with the Dow up by 347 points within a few minutes of the open. Left out of the party were Fannie and Freddie, both of which dropped more than 80% to the ignominy of penny-stock status...the Treasury today announced a $12B re-opening of the 10-year note, $1B more than the last re-opening...Swaps saw receiving in the belly, and swap spreads collapsed in on the back of agency and MBS tightening. Agencies saw light buying in 2- and 5-year paper, along with small selling in 10-years. After this weekend's GSE announcement, agency debt tightened 35bps in 2-years, 30bps in 3- to 10-year space, and 23bps in the long end. Versus swaps, the outperformance amounted to 27bps, 25bps, and 20bps, respectively. GSE sub-debt, which had taken a beating recently over uncertainty about their standing after any government intervention, benefited especially handsomely after this announcement. Although volume was light, front end sub-debt has tightened roughly 350bps versus Treasuries, and longer-maturity paper is about 250bps better. Mortgages saw convexity buying along with large scale rolling. There was servicer and fast-money buying in the morning, fast-money selling after lunch, and servicer buying later in the afternoon. Mortgages opened 40bps tighter to Treasuries and stayed within a few basis points of that all day. Today's moves in agency and mortgage spreads easily should easily set a record for the largest one-day moves of all time."

Three month T-Bill yield fell 7 bp at 1.70%
Two year T-Note yield unchanged at 2.30%
Ten year T-Note yield fell 2.5 bp to 3.67%
30-year FNMA current coupon fell 41 bp to 5.21%

Dow rose 290 points to 11,511
S&P rose 10 points to 1282

Dollar index rose .56 points to 79.49
Yen at 108.2Euro at 1.413
Gold fell $1 to $802
Oil rose $0.25 to $106.5

Consumer Credit Growth Slowing

Consumer credit growth slowed dramatically in July, rising at the slowest pace since last December, and June's high growth rate was revised substantially lower. In July, consumer spending rose +$4.6B (consensus $8.5B, prior (June) revised down to $11B from $14.3B previously). This report covers credit card and non-revolving debt, but doesn't include mortgage debt. The worsening employment market is restraining consumer debt growth. The pace of credit growth slowed to 5.3% YoY in July from 5.5% in June. The slump in auto sales to the lowest level in over a decade caused non-revolving debt, which includes auto loans, to rise at the slowest pace of the year, at $678 million in July. Revolving debt, which includes credit cardss, rose by $3.9B in July as banks raise interest rates and tighten credit. In July, revolving debt grew at an annual rate of 4.75% MoM and non-revolving credit rose by 0.5% MoM. The average maturity of an auto loan rose to 67.2 months from 63.5 months in June, and the loan-to-value ratio rose to 96% from 93% in June. Both figures are at 5-year highs.